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DISH NETWORK CORP - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following management's discussion and analysis of our financial condition and results of operations together with the audited consolidated financial statements and notes to our financial statements included elsewhere in this Annual Report. This management's discussion and analysis is intended to help provide an understanding of our financial condition, changes in financial condition and results of our operations and contains forward-looking statements that involve risks and uncertainties. The forward-looking statements are not historical facts, but rather are based on current expectations, estimates, assumptions and projections about our industry, business and future financial results. Our actual results could differ materially from the results contemplated by these forward-looking statements due to a number of factors, including those discussed in this report, including under the caption "Item 1A. Risk Factors" in this Annual Report on Form 10-K. EXECUTIVE SUMMARY Overview DISH added approximately 89,000 net Pay-TV subscribers during the year ended December 31, 2012, compared to a loss of approximately 166,000 net Pay-TV subscribers during the same period in 2011. The increase versus the same period in 2011 primarily resulted from a decrease in our average monthly Pay-TV subscriber churn rate and higher gross new Pay-TV subscriber activations due primarily to increased advertising associated with our Hopper set-top box. During the year ended December 31, 2012, DISH added approximately 2.739 million gross new Pay-TV subscribers compared to approximately 2.576 million gross new Pay-TV subscribers during the same period in 2011, an increase of 6.3%. Our gross new Pay-TV subscriber activations continue to be negatively impacted by increased competitive pressures, including aggressive marketing and discounted promotional offers. In addition, our gross new Pay-TV subscriber activations continue to be adversely affected by sustained economic weakness and uncertainty. Our average monthly Pay-TV subscriber churn rate for the year ended December 31, 2012 was 1.57% compared to 1.63% for the same period in 2011. Our Pay-TV subscriber churn rate was positively impacted in part because we did not have a programming package price increase in the first quarter 2012, but did during the same period in 2011. While Pay-TV subscriber churn improved compared to the same period in 2011, churn continues to be adversely affected by the increased competitive pressures discussed above. Our Pay-TV subscriber churn rate is also impacted by, among other things, the credit quality of previously acquired subscribers, our ability to consistently provide outstanding customer service, the aggressiveness of competitor subscriber acquisition efforts, and our ability to control piracy and other forms of fraud. On September 27, 2012, we began marketing our satellite broadband service under the dishNET brand. This service leverages advanced technology and high-powered satellites launched by Hughes and ViaSat to provide broadband coverage nationwide. This service primarily targets approximately 15 million rural residents that are underserved, or unserved, by wireline broadband, and provides download speeds of up to 10 Mbps. We lease the customer premise equipment to subscribers and generally pay Hughes and ViaSat a wholesale rate per subscriber on a monthly basis. Currently, we generally utilize our existing DISH distribution channels under similar incentive arrangements as our pay-TV business to acquire new broadband subscribers. In addition to the dishNET branded satellite broadband service, we also offer wireline voice and broadband services under the dishNET brand as a competitive local exchange carrier to consumers living in a 14-state region (Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington and Wyoming). Our dishNET branded wireline broadband service provides download speeds of up to 20 Mbps. We primarily bundle our dishNET branded services with our DISH branded pay-TV service, to offer customers a single bill, payment and customer service option, which includes a discount for bundled services. In addition, we market and sell our dishNET branded services on a stand-alone basis. 55 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued DISH added approximately 78,000 net broadband subscribers during the year ended December 31, 2012 compared to a loss of approximately 5,000 net broadband subscribers during the same period in 2011. This increase versus the same period in 2011 primarily resulted from higher gross new broadband subscriber activations driven by increased advertising associated with the launch of the dishNET branded broadband services. During the year ended December 31, 2012, DISH added approximately 121,000 gross new broadband subscribers compared to 30,000 gross new broadband subscribers during the same period in 2011. A significant percentage of these activations were in the fourth quarter 2012, driven by increased advertising associated with the launch of the dishNET branded broadband services. During the fourth quarter 2012, we added approximately 57,000 gross new broadband subscribers. Broadband services revenue was $95 million for the year ended December 31, 2012, 0.7% of our total "Subscriber-related revenue." "Net income (loss) attributable to DISH Network" for the year ended December 31, 2012 was $637 million, compared to $1.516 billion for the same period in 2011. During the year ended December 31, 2012, "Net income (loss) attributable to DISH Network" decreased primarily due to $730 million of litigation expense related to the Voom Settlement Agreement, higher subscriber-related expenses primarily from higher programming costs, increased advertising associated with our Hopper set-top box and the reversal of our accrued expenses related to the TiVo Inc. settlement during 2011. This decrease was partially offset by the non-cash gain of $99 million related to the conversion of our DBSD North America 7.5% Convertible Senior Secured Notes due 2009 in connection with the completion of the DBSD Transaction. See Note 10 in the Notes to the Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K. Our ability to compete successfully will depend on, among other things, our ability to continue to obtain desirable programming and deliver it to our subscribers at competitive prices. Programming costs represent a large percentage of our "Subscriber-related expenses" and the largest component of our total expense. We expect these costs to continue to increase, especially for local broadcast channels and sports programming. Going forward, our margins may face pressure if we are unable to renew our long-term programming contracts on favorable pricing and other economic terms. In addition, increases in programming costs could cause us to increase the rates that we charge our subscribers, which could in turn cause our existing Pay-TV subscribers to disconnect our service or cause potential new Pay-TV subscribers to choose not to subscribe to our service. Additionally, our gross new Pay-TV subscriber activations and Pay-TV subscriber churn rate may be negatively impacted if we are unable to renew our long-term programming contracts before they expire or if we lose access to programming as a result of disputes with programming suppliers. As the pay-TV industry has matured, we and our competitors increasingly must seek to attract a greater proportion of new subscribers from each other's existing subscriber bases rather than from first-time purchasers of pay-TV services. Some of our competitors have been especially aggressive by offering discounted programming and services for both new and existing subscribers. In addition, programming offered over the Internet has become more prevalent as the speed and quality of broadband networks have improved. Significant changes in consumer behavior with regard to the means by which they obtain video entertainment and information in response to digital media competition could materially adversely affect our business, results of operations and financial condition or otherwise disrupt our business. While economic factors have impacted the entire pay-TV industry, our relative performance has also been driven by issues specific to DISH. In the past, our Pay-TV subscriber growth has been adversely affected by signal theft and other forms of fraud and by operational inefficiencies at DISH. To combat signal theft and improve the security of our broadcast system, we completed the replacement of our Security Access Devices to re-secure our system during 2009. We expect that additional future replacements of these devices will be necessary to keep our system secure. To combat other forms of fraud, we continue to expect that our third party distributors and retailers will adhere to our business rules. While we have made improvements in responding to and dealing with customer service issues, we continue to focus on the prevention of these issues, which is critical to our business, financial position and results of operations. We implemented a new billing system as well as new sales and customer care systems in the first quarter 2012. To improve our operational performance, we continue to make significant investments in staffing, training, information systems, and other initiatives, primarily in our call center and in-home service operations. These investments are intended to help combat inefficiencies introduced by the increasing complexity of our business, improve customer 56 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued satisfaction, reduce churn, increase productivity, and allow us to scale better over the long run. We cannot, however, be certain that our spending will ultimately be successful in improving our operational performance. We have been deploying receivers that utilize 8PSK modulation technology and receivers that utilize MPEG-4 compression technology for several years. These technologies, when fully deployed, will allow more programming channels to be carried over our existing satellites. Many of our customers today, however, do not have receivers that use MPEG-4 compression and a smaller but still significant number of our customers do not have receivers that use 8PSK modulation. We may choose to invest significant capital to accelerate the conversion of customers to MPEG-4 and/or 8PSK to realize the bandwidth benefits sooner. In addition, given that all of our HD content is broadcast in MPEG-4, any growth in HD penetration will naturally accelerate our transition to these newer technologies and may increase our subscriber acquisition and retention costs. All new receivers that we purchase from EchoStar have MPEG-4 technology. Although we continue to refurbish and redeploy MPEG-2 receivers, as a result of our HD initiatives and current promotions, we currently activate most new customers with higher priced MPEG-4 technology. This limits our ability to redeploy MPEG-2 receivers and, to the extent that our promotions are successful, will accelerate the transition to MPEG-4 technology, resulting in an adverse effect on our acquisition costs per new subscriber activation. From time to time, we change equipment for certain subscribers to make more efficient use of transponder capacity in support of HD and other initiatives. We believe that the benefit from the increase in available transponder capacity outweighs the short-term cost of these equipment changes. To maintain and enhance our competitiveness over the long term, we introduced the Hopper set-top box, that allows, among other things, recorded programming to be viewed in HD in multiple rooms. During the second quarter 2012, the four major broadcast television networks filed lawsuits against us alleging, among other things, that the PrimeTime Anytime and AutoHop features of the Hopper set-top box infringe their copyrights. In the event a court ultimately determines that we infringe the asserted copyrights, we may be subject to, among other things, an injunction that could require us to materially modify or cease to offer these features. See Note 16 in the Notes to the Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K for further information. We recently introduced the Hopper set-top box with Sling, which promotes a suite of integrated products designed to maximize the convenience and ease of watching TV anytime and anywhere, which we refer to as DISH Anywhere™ that utilizes, among other things, online access and Slingbox "placeshifting" technology. In addition, the Hopper with Sling has several innovative features which allows customers to watch and record television programming through certain tablet computers and combines program-discovery tools, social media engagement and remote-control capabilities through the use of certain tablet computers. There can be no assurance that these integrated products will positively affect our results of operations or our gross new subscriber activations. Blockbuster On April 26, 2011, we completed the Blockbuster Acquisition for a net purchase price of $234 million. This transaction was accounted for as a business combination and therefore the purchase price was allocated to the assets acquired based on their estimated fair value. Blockbuster primarily offers movies and video games for sale and rental through multiple distribution channels such as retail stores, by-mail, the blockbuster.com website and the BLOCKBUSTER On Demand service. The Blockbuster Acquisition is intended to complement our core business of delivering high-quality video entertainment to consumers. We are promoting our new Blockbuster offerings including the Blockbuster@Home™ service which provides movies, games and TV shows through Internet streaming, mail and in-store exchanges and online. This offering is only available to DISH subscribers. Blockbuster operations are included in our financial results beginning April 26, 2011. During the year ended December 31, 2012, Blockbuster operations contributed $1.088 billion in revenue with a $35 million operating loss compared to $975 million in revenue and $1 million in operating loss for the same period in 2011. The operating loss during the year ended December 31, 2012 was impacted by a charge of $21 million to "Cost of sales - equipment, merchandise, services, rental and other" as a result of the Blockbuster UK Administration, discussed below. In addition, this operating loss resulted from lower monthly revenue and higher inventory costs per unit relative to the fair value of the inventory costs per unit acquired in the Blockbuster Acquisition, partially offset by the benefit from the sale of inventory from domestic retail stores that were closed primarily during the first half of 2012. During 2012, we closed approximately 700 domestic retail stores, leaving us with approximately 800 57 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued domestic retail stores as of December 31, 2012. In January 2013, we announced the closing of approximately 300 additional domestic retail stores. We continue to evaluate the impact of certain factors, including, among other things, competitive pressures, the ability of significantly fewer Blockbuster domestic retail stores to continue to support corporate administrative costs, and other issues impacting the store-level financial performance of our Blockbuster domestic retail stores. These factors, or other reasons, could lead us to close additional Blockbuster domestic retail stores. In addition, to reduce administrative expenses, we moved the Blockbuster headquarters to Denver during June 2012. Our Blockbuster UK Operating Entities entered into Administration in the United Kingdom on January 16, 2013. Administrators have been appointed by the English courts to sell or liquidate the assets of the Blockbuster UK Operating Entities for the benefit of their creditors. Since we no longer exercise control and the administrator now exercises control over all operating decisions for the Blockbuster UK Operating Entities, we will be required to deconsolidate Blockbuster UK during the first quarter 2013. As a result of the Administration, we have written down the assets of Blockbuster UK to their estimated net realizable value on our Consolidated Balance Sheets as of December 31, 2012, and we recorded a charge to "Cost of sales - equipment, merchandise, services, rental and other" of $21 million during the year ended December 31, 2012 on our Consolidated Statements of Operations and Comprehensive Income (Loss). Furthermore, we have intercompany receivables due from Blockbuster UK of approximately $37 million that are eliminated in consolidation on our Consolidated Balance Sheets as of December 31, 2012. Upon deconsolidation of Blockbuster UK in the first quarter 2013, these intercompany receivables will no longer be eliminated in consolidation. We currently believe that we will not receive the entire amount for these intercompany receivables in the Administration. Accordingly, we recorded a $25 million impairment charge related to these intercompany receivables, to adjust this amount to their estimated net realizable value for the year ended December 31, 2012. This impairment charge was recorded in "Other, net" within "Other Income (Expense)" on our Consolidated Statements of Operations and Comprehensive Income (Loss) and the resulting liability was recorded in "Other accrued expenses" on our Consolidated Balance Sheets as of December 31, 2012. The $25 million impairment liability will be offset against the intercompany receivables that will be recorded upon deconsolidation in the first quarter 2013. In total, we recorded charges described above totaling approximately $46 million on a pre-tax basis on our Consolidated Statements of Operations and Comprehensive Income (Loss) for the year ended December 31, 2012 related to the Administration. The proceeds that we actually receive from the Administration and the actual impairment charge may differ from our estimates. As of December 31, 2012, Blockbuster UK had total assets and liabilities as follows (in thousands): Cash $ 14,072 Trade accounts receivable 1,153 Inventory 34,937 Other current assets 10,243 Restricted cash and marketable securities 484 Property and equipment 186 Trade accounts payable (13,081 ) Intercompany payable (36,676 ) Deferred revenue and other (1,369 ) Other accrued expenses (9,949 ) Total net assets $ - Upon deconsolidation in the first quarter 2013, the above amounts will be combined into one net asset and the intercompany receivables of $37 million, net of the impairment liability of $25 million described above, will be recorded in "Other noncurrent assets, net" on our Consolidated Balance Sheets as a component of our investment in Blockbuster UK. For the years ended December 31, 2012 and 2011, Blockbuster UK had $293 million and $242 million of revenue, respectively. In addition, for the years ended December 31, 2012 and 2011, Blockbuster UK had an operating loss of $31 million and operating income of $16 million, respectively. Upon deconsolidation in the first quarter 2013, 58 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued the revenue and expenses related to Blockbuster UK will no longer be recorded in our Consolidated Financial Statements. Our Consolidated Statements of Operations and Comprehensive Income (Loss) for the years ended December 31, 2012 and 2011 include the results of operations for Blockbuster for twelve months and eight months, respectively. We did not have any Blockbuster activity during 2010 as we acquired Blockbuster on April 26, 2011. Therefore, our results of operations for the years ended December 31, 2012, 2011 and 2010 are not comparable. Wireless Spectrum In 2008, we paid $712 million to acquire certain 700 MHz wireless spectrum licenses, which were granted to us by the FCC in February 2009 subject to certain build-out requirements. On March 2, 2012, the FCC approved the transfer of 40 MHz of 2 GHz wireless spectrum licenses held by DBSD North America and TerreStar to us. On March 9, 2012, we completed the DBSD Transaction and the TerreStar Transaction, pursuant to which we acquired, among other things, certain satellite assets and wireless spectrum licenses held by DBSD North America and TerreStar. In addition, during the fourth quarter 2011, we and Sprint entered into the Sprint Settlement Agreement pursuant to which all issues then being disputed relating to the DBSD Transaction and the TerreStar Transaction were resolved between us and Sprint, including, but not limited to, issues relating to costs allegedly incurred by Sprint to relocate users from the spectrum then licensed to DBSD North America and TerreStar. Pursuant to the Sprint Settlement Agreement, we made a net payment of approximately $114 million to Sprint. The total consideration to acquire these assets was approximately $2.860 billion. This amount includes $1.364 billion for the DBSD Transaction, $1.382 billion for the TerreStar Transaction, and the net payment of $114 million to Sprint pursuant to the Sprint Settlement Agreement. The financial results of DBSD North America and TerreStar are included in our results beginning March 9, 2012. We generated $1 million and less than $1 million of revenue for the years ended December 31, 2012 and 2011, respectively from our wireless spectrum segment. In addition, we incurred a $64 million operating loss and less than $1 million in operating income for the years ended December 31, 2012 and 2011, respectively. We incur general and administrative expenses associated with certain satellite operations and regulatory compliance matters from our wireless spectrum assets. We also incur depreciation and amortization expenses associated with certain assets of DBSD North America and TerreStar. This depreciation and amortization expense is based on our estimate of the fair value of these assets as disclosed in Note 10 in the Notes to the Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K. As we review our options for the commercialization of this wireless spectrum, we may incur significant additional expenses and may have to make significant investments related to, among other things, research and development, wireless testing and construction of a wireless network. Operational Liquidity Like many companies, we make general investments in property such as satellites, set-top boxes, information technology and facilities that support our overall business. However, since we are primarily a subscriber-based company, we also make subscriber-specific investments to acquire new subscribers and retain existing subscribers. While the general investments may be deferred without impacting the business in the short-term, the subscriber-specific investments are less discretionary. Our overall objective is to generate sufficient cash flow over the life of each subscriber to provide an adequate return against the upfront investment. Once the upfront investment has been made for each subscriber, the subsequent cash flow is generally positive. There are a number of factors that impact our future cash flow compared to the cash flow we generate at a given point in time. The first factor is how successful we are at retaining our current subscribers. As we lose subscribers from our existing base, the positive cash flow from that base is correspondingly reduced. The second factor is how successful we are at maintaining our subscriber-related margins. To the extent our "Subscriber-related expenses" grow faster than our "Subscriber-related revenue," the amount of cash flow that is generated per existing subscriber is reduced. The third factor is the rate at which we acquire new subscribers. The faster we acquire new subscribers, the more our positive ongoing cash flow from existing subscribers is offset by the negative upfront cash flow associated with new subscribers. Finally, our future cash flow is impacted by the rate at which we make general investments and any cash flow from financing activities. 59 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Our subscriber-specific investments to acquire new subscribers have a significant impact on our cash flow. While fewer subscribers might translate into lower ongoing cash flow in the long-term, cash flow is actually aided, in the short-term, by the reduction in subscriber-specific investment spending. As a result, a slow down in our business due to external or internal factors does not introduce the same level of short-term liquidity risk as it might in other industries. Availability of Credit and Effect on Liquidity The ability to raise capital has generally existed for us despite the weak economic conditions. Modest fluctuations in the cost of capital will not likely impact our current operational plans. Future Liquidity Wireless Spectrum On March 2, 2012, the FCC approved the transfer of 40 MHz of 2 GHz wireless spectrum licenses held by DBSD North America and TerreStar to us. On March 9, 2012, we completed the DBSD Transaction and the TerreStar Transaction, pursuant to which we acquired, among other things, certain satellite assets and wireless spectrum licenses held by DBSD North America and TerreStar. The total consideration to acquire these assets was approximately $2.860 billion. This amount includes $1.364 billion for the DBSD Transaction, $1.382 billion for the TerreStar Transaction, and the net payment of $114 million to Sprint pursuant to the Sprint Settlement Agreement. Our consolidated FCC applications for approval of the license transfers from DBSD North America and TerreStar were accompanied by requests for waiver of the FCC's Mobile Satellite Service ("MSS") "integrated service" and spare satellite requirements and various technical provisions. The FCC denied our requests for waiver of the integrated service and spare satellite requirements but did not initially act on our request for waiver of the various technical provisions. On March 21, 2012, the FCC released a Notice of Proposed Rule Making ("NPRM") proposing the elimination of the integrated service, spare satellite and various technical requirements attached to the 2 GHz licenses. On December 11, 2012, the FCC approved rules that eliminated these requirements and gave notice of its proposed modification of our 2 GHz authorizations to, among other things, allow us to offer single-mode terrestrial terminals to customers who do not desire satellite functionality. On February 15, 2013, the FCC issued an order, which will become effective on March 7, 2013, modifying our 2 GHz licenses to add terrestrial operating authority. The FCC's order of modification has imposed certain limitations on the use of a portion of this spectrum, including interference protections for other spectrum users and power and emission limits that we presently believe could render 5 MHz of our uplink spectrum effectively unusable for terrestrial services and limit our ability to fully utilize the remaining 15 MHz of our uplink spectrum for terrestrial services. These limitations could, among other things, impact the finalization of technical standards associated with our wireless business, and may have a material adverse effect on our ability to commercialize these licenses. The new rules also mandate certain interim and final build-out requirements for the licenses. By March 2017, we must provide terrestrial signal coverage and offer terrestrial service to at least 40% of the aggregate population represented by all of the areas covered by the licenses (the "2 GHz Interim Build-out Requirement"). By March 2020, we must provide terrestrial signal coverage and offer terrestrial service to at least 70% of the population in each area covered by an individual license (the "2 GHz Final Build-out Requirement"). If we fail to meet the 2 GHz Interim Build-out Requirement, the 2 GHz Final Build-out Requirement will be accelerated by one year, from March 2020 to March 2019. If we fail to meet the 2 GHz Final Build-out Requirement, our terrestrial authorization for each license area in which we fail to meet the requirement will terminate. In addition, the FCC is currently considering rules for a spectrum band that is adjacent to our 2 GHz licenses, known as the "H Block." If the FCC adopts rules for the H block that do not adequately protect our 2 GHz licenses, there could be a material adverse effect on our ability to commercialize the 2 GHz licenses. As a result of the completion of the DBSD Transaction and the TerreStar Transaction, we will likely be required to make significant additional investments or partner with others to, among other things, finance the commercialization and build-out requirements of these licenses and our integration efforts including compliance with regulations applicable to the acquired licenses. Depending on the nature and scope of such commercialization, build-out, and integration efforts, any such investment or partnership could vary significantly. Additionally, recent consolidation 60 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued in the wireless telecommunications industry, may, among other things, limit our available options, including our ability to partner with others. There can be no assurance that we will be able to develop and implement a business model that will realize a return on these spectrum licenses or that we will be able to profitably deploy the assets represented by these spectrum licenses, which may affect the carrying value of these assets and our future financial condition or results of operations. In 2008, we paid $712 million to acquire certain 700 MHz wireless spectrum licenses, which were granted to us by the FCC in February 2009. These licenses mandate certain interim and final build-out requirements. By June 2013, we must provide signal coverage and offer service to at least 35% of the geographic area in each area covered by each individual license (the "700 MHz Interim Build-out Requirement"). By the end of our license term (June 2019), we must provide signal coverage and offer service to at least 70% of the geographic area in each area covered by each individual license (the "700 MHz Final Build-out Requirement"). We have recently notified the FCC of our plans to commence signal coverage in select cities within certain of these areas, but we have not yet developed plans for providing signal coverage and offering service in all of these areas. If we fail to meet the 700 MHz Interim Build-out Requirement, the term of our licenses will be reduced, from June 2019 to June 2017, and we could face possible fines and the reduction of license area(s). If we fail to meet the 700 MHz Final Build-out Requirement, our authorization for each license area in which we fail to meet the requirement will terminate. To commercialize these licenses and satisfy the associated FCC build-out requirements, we will be required to make significant additional investments or partner with others. Depending on the nature and scope of such commercialization and build-out, any such investment or partnership could vary significantly. We have recently been engaged in discussions regarding a potential strategic transaction with Clearwire. On January 8, 2013, Clearwire issued a press release summarizing the proposed transaction at that time. Later that day, we confirmed that we had formally approached Clearwire with respect to a potential strategic transaction on the terms and conditions generally outlined in Clearwire's press release. The terms and conditions for a potential strategic transaction at that time disclosed by Clearwire generally provided for the following, among others: (i) we would acquire approximately 24% of Clearwire's total spectrum, for approximately $2.2 billion; and (ii) we would make an offer to purchase up to all of Clearwire's outstanding shares at a price of $3.30 per share in cash. This offer would be subject to certain conditions, including that we acquire no less than 25% of the fully-diluted shares of Clearwire and receive certain governance and minority protection rights. There is no assurance that we will continue discussions with Clearwire or that we will ultimately be able to conclude a transaction with Clearwire upon the terms outlined above or at all. To the extent that we are able to conclude a transaction with Clearwire, we may be required to commit a significant portion of our cash and marketable securities to fund these arrangements, and these commitments may cause us to defer or curtail investments in our core business, strategic investments, share repurchases or other transactions that we otherwise may have made. Furthermore, Clearwire has experienced significant operating and financial challenges in its recent history. Therefore, any investment we may make in Clearwire will be speculative, and we may lose all of the investment. In addition, we may be required to spend additional capital or raise additional capital to support an investment in Clearwire's business and to build out a network to utilize the spectrum acquired, which may not be available on acceptable terms or at all. There can be no assurance that we will be able to develop and implement a business model that will realize a return on a possible transaction with Clearwire or that we will be able to profitably deploy the spectrum assets, which may affect the carrying value of these assets and our future financial condition or results of operations. If we are unable to successfully address these challenges and risks, our business, financial condition or results of operations will likely suffer. 61 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued EXPLANATION OF KEY METRICS AND OTHER ITEMS Subscriber-related revenue. "Subscriber-related revenue" consists principally of revenue from basic, premium movie, local, HD programming, pay-per-view, Latino and international subscription television services, broadband services, equipment rental fees and other hardware related fees, including fees for DVRs, fees for broadband equipment, equipment upgrade fees and additional outlet fees from subscribers with receivers with multiple tuners, advertising services, fees earned from our in-home service operations and other subscriber revenue. Certain of the amounts included in "Subscriber-related revenue" are not recurring on a monthly basis. Equipment and merchandise sales, rental and other revenue. "Equipment and merchandise sales, rental and other revenue" principally includes the non-subsidized sales of DBS accessories to retailers and other third-party distributors of our equipment domestically and to Pay-TV subscribers. Effective April 26, 2011, revenue from merchandise sold to customers including movies, video games and other items, and revenue from the rental of movies and video games and the sale of previously rented titles related to our Blockbuster operations are included in this category. Equipment sales, services and other revenue - EchoStar. "Equipment sales, services and other revenue - EchoStar" includes revenue related to equipment sales, services, and other agreements with EchoStar. Subscriber-related expenses. "Subscriber-related expenses" principally include programming expenses, which represent a substantial majority of these expenses. "Subscriber-related expenses" also include costs for pay-TV and broadband services incurred in connection with our in-home service and call center operations, billing costs, refurbishment and repair costs related to receiver systems, subscriber retention, other variable subscriber expenses and monthly wholesale fees paid to broadband providers. Prior to the fourth quarter 2012, certain costs related to the acquisition of new broadband subscribers were included in this category. Beginning in the fourth quarter 2012, our "Subscriber-related expenses" exclude these costs related to the acquisition of new broadband subscribers. During the fourth quarter 2012, expenses related to the acquisition of new broadband subscribers for the period beginning January 1, 2012 through September 30, 2012 that were previously included in "Subscriber-related expenses" were reclassified to "Subscriber acquisition costs." These amounts associated with the acquisition of new broadband subscribers for prior years were immaterial. Satellite and transmission expenses - EchoStar. "Satellite and transmission expenses - EchoStar" includes the cost of leasing satellite and transponder capacity from EchoStar and the cost of digital broadcast operations provided to us by EchoStar, including satellite uplinking/downlinking, signal processing, conditional access management, telemetry, tracking and control, and other professional services. Satellite and transmission expenses - other. "Satellite and transmission expenses - other" includes executory costs associated with capital leases and costs associated with transponder leases and other related services. Effective March 9, 2012, expenses related to our wireless spectrum segment are included in this category. Cost of sales - equipment, merchandise, services, rental and other. "Cost of sales - equipment, merchandise, services, rental and other" principally includes the cost of non-subsidized sales of DBS accessories to retailers and other third-party distributors of our equipment domestically and to Pay-TV subscribers. Effective April 26, 2011, the cost of movies and video games including rental title purchases or revenue sharing to studios, packaging and online delivery costs and cost of merchandise sold including movies, video games and other items related to our Blockbuster operations are included in this category. In addition, "Cost of sales - equipment, merchandise, services, rental and other" includes costs related to equipment sales, services, and other agreements with EchoStar. Subscriber acquisition costs. In addition to leasing receivers, we generally subsidize installation and all or a portion of the cost of our receiver systems to attract new Pay-TV subscribers. Our "Subscriber acquisition costs" include the cost of subsidized sales of receiver systems to retailers and other third-party distributors of our equipment, the cost of subsidized sales of receiver systems directly by us to subscribers, including net costs related to our promotional incentives, costs related to our direct sales efforts and costs related to installation and acquisition advertising. In addition, beginning in the fourth quarter 2012, our "Subscriber acquisition costs" include the cost of sales, direct sales efforts and costs related to installations associated with our broadband services. During the fourth quarter 2012, certain expenses related to our broadband services for the period beginning January 1, 2012 through September 30, 62 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued 2012 that were previously included in "Subscriber-related expenses" were reclassified to "Subscriber acquisition costs." These amounts associated with our broadband services for 2011 were immaterial. We exclude the value of equipment capitalized under our lease program for new Pay-TV and broadband subscribers from "Subscriber acquisition costs." Pay-TV SAC. Subscriber acquisition cost measures are commonly used by those evaluating companies in the Pay-TV industry. We are not aware of any uniform standards for calculating the "average subscriber acquisition costs per new Pay-TV subscriber activation," or Pay-TV SAC, and we believe presentations of Pay-TV SAC may not be calculated consistently by different companies in the same or similar businesses. Our Pay-TV SAC is calculated as "Subscriber acquisition costs," excluding "Subscriber acquisition costs" associated with our broadband services, plus the value of equipment capitalized under our lease program for new Pay-TV subscribers, divided by gross new Pay-TV subscriber activations. We include all the costs of acquiring Pay-TV subscribers (e.g., subsidized and capitalized equipment) as we believe it is a more comprehensive measure of how much we are spending to acquire subscribers. We also include all new Pay-TV subscribers in our calculation, including Pay-TV subscribers added with little or no subscriber acquisition costs. During the fourth quarter 2012, we have elected to provide Pay-TV SAC rather than SAC, defined below, as we believe Pay-TV SAC provides a more meaningful metric. SAC. Historically, we have calculated SAC as "Subscriber acquisition costs," plus the value of equipment capitalized under our lease program for new subscribers, divided by gross new subscriber activations. This metric included the cost (e.g., subsidized and capitalized equipment) of acquiring Pay-TV subscribers and certain costs of acquiring broadband subscribers. We also included all new Pay-TV subscribers in our calculation, including Pay-TV subscribers added with little or no subscriber acquisition costs. During the fourth quarter 2012, we have elected to discontinue providing SAC as we believe Pay-TV SAC, which excludes broadband subscriber acquisition costs, provides a more meaningful metric. General and administrative expenses. "General and administrative expenses" consists primarily of employee-related costs associated with administrative services such as legal, information systems, accounting and finance, including non-cash, stock-based compensation expense. It also includes outside professional fees (e.g., legal, information systems and accounting services) and other items associated with facilities and administration. Litigation expense. "Litigation expense" primarily consists of legal settlements, judgments or accruals associated with certain significant litigation. Interest expense, net of amounts capitalized. "Interest expense, net of amounts capitalized" primarily includes interest expense, prepayment premiums and amortization of debt issuance costs associated with our senior debt (net of capitalized interest), and interest expense associated with our capital lease obligations. Other, net. The main components of "Other, net" are gains and losses realized on the sale and/or conversion of investments, impairment of marketable and non-marketable investment securities, unrealized gains and losses from changes in fair value of marketable and non-marketable strategic investments accounted for at fair value, and equity in earnings and losses of our affiliates. Earnings before interest, taxes, depreciation and amortization ("EBITDA"). EBITDA is defined as "Net income (loss) attributable to DISH Network" plus "Interest expense, net of amounts capitalized" net of "Interest income," "Income tax (provision) benefit, net" and "Depreciation and amortization." This "non-GAAP measure" is reconciled to "Net income (loss) attributable to DISH Network" in our discussion of "Results of Operations" below. "Pay-TV subscribers." We include customers obtained through direct sales, third-party retailers and other third-party distribution relationships in our Pay-TV subscriber count. We also provide pay-TV service to hotels, motels and other commercial accounts. For certain of these commercial accounts, we divide our total revenue for these commercial accounts by an amount approximately equal to the retail price of our DISH America programming package, and include the resulting number, which is substantially smaller than the actual number of commercial units served, in our Pay-TV subscriber count. Effective during the first quarter 2011, we made two changes to this calculation methodology compared to prior periods. Beginning February 1, 2011, the retail price of our DISH America programming package was used in the calculation rather than America's Top 120 programming package, which had been used in prior periods. We also determined that two of our commercial business lines, which had 63 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued previously been included in the described calculation, could be more accurately reflected through actual subscriber counts. The net impact of these two changes was to increase our subscriber count by approximately 6,000 subscribers in the first quarter 2011. Prior period Pay-TV subscriber counts have not been adjusted for this revised commercial accounts calculation as the impacts were immaterial. "Broadband subscribers." During the fourth quarter 2012, we elected to provide certain broadband subscriber data. Each broadband customer is counted as one broadband subscriber, regardless of whether they are also a Pay-TV subscriber. A subscriber of both our pay-TV and broadband services is counted as one Pay-TV subscriber and one broadband subscriber. Pay-TV average monthly revenue per subscriber ("Pay-TV ARPU"). We are not aware of any uniform standards for calculating ARPU and believe presentations of ARPU may not be calculated consistently by other companies in the same or similar businesses. We calculate Pay-TV average monthly revenue per subscriber, or Pay-TV ARPU, by dividing average monthly "Subscriber-related revenue," excluding revenue from broadband services, for the period by our average number of Pay-TV subscribers for the period. The average number of Pay-TV subscribers is calculated for the period by adding the average number of Pay-TV subscribers for each month and dividing by the number of months in the period. The average number of Pay-TV subscribers for each month is calculated by adding the beginning and ending Pay-TV subscribers for the month and dividing by two. During the fourth quarter 2012, we have elected to provide Pay-TV ARPU rather than APRU, defined below, as we believe Pay-TV ARPU provides a more meaningful metric. Average monthly revenue per subscriber ("ARPU"). Historically, we have calculated ARPU by dividing average monthly "Subscriber-related revenue" for the period by our average number of Pay-TV subscribers for the period. The average number of Pay-TV subscribers was calculated for the period by adding the average number of Pay-TV subscribers for each month and dividing by the number of months in the period. The average number of Pay-TV subscribers for each month was calculated by adding the beginning and ending Pay-TV subscribers for the month and dividing by two. During the fourth quarter 2012, we have elected to discontinue providing ARPU as we believe Pay-TV ARPU, which excludes revenue from broadband services, provides a more meaningful metric. Pay-TV average monthly subscriber churn rate ("Pay-TV churn rate"). We are not aware of any uniform standards for calculating subscriber churn rate and believe presentations of subscriber churn rates may not be calculated consistently by different companies in the same or similar businesses. We calculate Pay-TV churn rate for any period by dividing the number of Pay-TV subscribers who terminated service during the period by the average number of Pay-TV subscribers for the same period, and further dividing by the number of months in the period. When calculating Pay-TV subscriber churn, the same methodology for calculating average number of Pay-TV subscribers is used as when calculating Pay-TV ARPU. Free cash flow. We define free cash flow as "Net cash flows from operating activities" less "Purchases of property and equipment," as shown on our Consolidated Statements of Cash Flows. 64 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued RESULTS OF OPERATIONS Year Ended December 31, 2012 Compared to the Year Ended December 31, 2011. For the Years Ended December 31, Variance Statements of Operations Data 2012 2011 Amount % (In thousands) Revenue: Subscriber-related revenue $ 13,085,910 $ 12,976,009 $ 109,901 0.8 Equipment and merchandise sales, rental and other revenue 1,162,664 1,035,910 126,754 12.2 Equipment sales, services and other revenue - EchoStar 17,918 36,474 (18,556 ) (50.9 ) Total revenue 14,266,492 14,048,393 218,099 1.6 Costs and Expenses: Subscriber-related expenses 7,254,458 6,845,611 408,847 6.0 % of Subscriber-related revenue 55.4 % 52.8 % Satellite and transmission expenses - EchoStar 424,543 441,541 (16,998 ) (3.8 ) % of Subscriber-related revenue 3.2 % 3.4 % Satellite and transmission expenses - Other 41,697 39,806 1,891 4.8 % of Subscriber-related revenue 0.3 % 0.3 % Cost of sales - equipment, merchandise, services, rental and other 569,626 448,686 120,940 27.0 Subscriber acquisition costs 1,687,327 1,505,177 182,150 12.1 General and administrative expenses 1,353,500 1,234,494 119,006 9.6 % of Total revenue 9.5 % 8.8 % Litigation expense 730,457 (316,949 ) 1,047,406 * Depreciation and amortization 983,049 922,073 60,976 6.6 Total costs and expenses 13,044,657 11,120,439 1,924,218 17.3 Operating income (loss) 1,221,835 2,927,954 (1,706,119 ) (58.3 ) Other Income (Expense): Interest income 99,522 34,354 65,168 * Interest expense, net of amounts capitalized (536,879 ) (557,910 ) 21,031 3.8 Other, net 148,291 6,186 142,105 * Total other income (expense) (289,066 ) (517,370 ) 228,304 44.1 Income (loss) before income taxes 932,769 2,410,584 (1,477,815 ) (61.3 ) Income tax (provision) benefit, net (307,029 ) (895,006 ) 587,977 65.7 Effective tax rate 32.9 % 37.1 % Net income (loss) 625,740 1,515,578 (889,838 ) (58.7 ) Less: Net income (loss) attributable to noncontrolling interest (10,947 ) (329 ) (10,618 ) * Net income (loss) attributable to DISH Network $ 636,687 $ 1,515,907 $ (879,220 ) (58.0 ) Other Data: Pay-TV subscribers, as of period end (in millions) 14.056 13.967 0.089 0.6 Pay-TV subscriber additions, gross (in millions) 2.739 2.576 0.163 6.3 Pay-TV subscriber additions, net (in millions) 0.089 (0.166 ) 0.255 * Pay-TV average monthly subscriber churn rate 1.57 % 1.63 % (0.06 )% (3.7 ) Pay-TV average subscriber acquisition cost per subscriber ("Pay-TV SAC") $ 784 $ 770 $ 14 1.8 Pay-TV average monthly revenue per subscriber ("Pay-TV ARPU") $ 77.10 $ 76.45 $ 0.65 0.9 Broadband subscribers, as of period end (in millions) 0.183 0.105 0.078 74.3 Broadband subscriber additions, gross (in millions) 0.121 0.030 0.091 * Broadband subscriber additions, net (in millions) 0.078 (0.005 ) 0.083 * EBITDA $ 2,364,122 $ 3,856,542 $ (1,492,420 ) (38.7 ) -------------------------------------------------------------------------------- * Percentage is not meaningful. 65 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Pay-TV subscribers. DISH added approximately 89,000 net Pay-TV subscribers during the year ended December 31, 2012, compared to a loss of approximately 166,000 net Pay-TV subscribers during the same period in 2011. The increase versus the same period in 2011 primarily resulted from a decrease in our average monthly Pay-TV subscriber churn rate and higher gross new Pay-TV subscriber activations due primarily to increased advertising associated with our Hopper set-top box. During the year ended December 31, 2012, DISH added approximately 2.739 million gross new Pay-TV subscribers compared to approximately 2.576 million gross new Pay-TV subscribers during the same period in 2011, an increase of 6.3%. Our gross new Pay-TV subscriber activations continue to be negatively impacted by increased competitive pressures, including aggressive marketing and discounted promotional offers. Telecommunications companies have continued to grow their pay-TV customer bases. In addition, our gross new Pay-TV subscriber activations continue to be adversely affected by sustained economic weakness and uncertainty. Our average monthly Pay-TV subscriber churn rate for the year ended December 31, 2012 was 1.57% compared to 1.63% for the same period in 2011. Our Pay-TV subscriber churn rate was positively impacted in part because we did not have a programming package price increase in the first quarter 2012, but did during the same period in 2011. While Pay-TV subscriber churn improved compared to the same period in 2011, churn continues to be adversely affected by the increased competitive pressures discussed above. Our Pay-TV subscriber churn rate is also impacted by, among other things, the credit quality of previously acquired subscribers, our ability to consistently provide outstanding customer service, the aggressiveness of competitor subscriber acquisition efforts, and our ability to control piracy and other forms of fraud. We have not always met our own standards for performing high-quality installations, effectively resolving subscriber issues when they arise, answering subscriber calls in an acceptable timeframe, effectively communicating with our subscriber base, reducing calls driven by the complexity of our business, improving the reliability of certain systems and subscriber equipment, and aligning the interests of certain third party retailers and installers to provide high-quality service. Most of these factors have affected both gross new Pay-TV subscriber activations as well as existing Pay-TV churn rate. Our future gross new Pay-TV subscriber activations and Pay-TV churn rate may be negatively impacted by these factors, which could in turn adversely affect our revenue growth. Broadband subscribers. DISH added approximately 78,000 net broadband subscribers during the year ended December 31, 2012, compared to a loss of approximately 5,000 net broadband subscribers during the same period in 2011. This increase versus the same period in 2011 primarily resulted from higher gross new broadband subscriber activations driven by increased advertising associated with the launch of dishNET branded broadband services. During the year ended December 31, 2012, DISH added approximately 121,000 gross new broadband subscribers compared to approximately 30,000 gross new broadband subscribers during the same period in 2011. The pace of net broadband subscriber activations increased in the fourth quarter primarily driven by increased advertising associated with the launch of dishNET branded broadband services. Of the 2012 net broadband subscriber activations, 34,000 occurred during the nine months ended September 30, 2012 and 44,000 occurred during the three months ended December 31, 2012. The following table details gross and net broadband subscriber additions by quarter for the year ended December 31, 2012. Gross Net Broadband Subscribers Additions Additions (In thousands) First Quarter, 2012 14 6 Second Quarter, 2012 21 11 Third Quarter, 2012 29 17 Fourth Quarter, 2012 57 44 Total 121 78 Subscriber-related revenue. "Subscriber-related revenue" totaled $13.086 billion for the year ended December 31, 2012, an increase of $110 million or 0.8% compared to the same period in 2011. The change in "Subscriber-related revenue" from the previous year was primarily related to the increase in Pay-TV ARPU discussed below. Included 66 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued in "Subscriber-related revenue" is $95 million and $81 million of revenue related to our broadband services for the years ended December 31, 2012 and 2011, respectively. Pay-TV ARPU. "Pay-TV average monthly revenue per subscriber" was $77.10 during the year ended December 31, 2012 versus $76.45 during the same period in 2011. The $0.65 or 0.9% increase in Pay-TV ARPU was primarily attributable to higher hardware related revenue. The following table details Pay-TV ARPU by quarter for the year ended December 31, 2012. Pay-TV Pay-TV ARPU ARPU First Quarter, 2012 $ 76.24 Second Quarter, 2012 77.59 Third Quarter, 2012 76.99 Fourth Quarter, 2012 77.59 Year-to-date, 2012 77.10 Equipment and merchandise sales, rental and other revenue. "Equipment and merchandise sales, rental and other revenue" totaled $1.163 billion for the year ended December 31, 2012, an increase of $127 million compared to the same period in 2011. This increase was primarily driven by a full year of revenue in 2012 compared to approximately eight months in the previous year from the rental of movies and video games, the sale of previously rented titles, and other merchandise sold to customers including movies, video games and other items related to our Blockbuster operations. Blockbuster operations are included in our financial results beginning April 26, 2011. This increase was partially offset by a decline in revenue as a result of Blockbuster domestic store closings during 2012 and 2011. Subscriber-related expenses. "Subscriber-related expenses" totaled $7.254 billion during the year ended December 31, 2012, an increase of $409 million or 6.0% compared to the same period in 2011. The increase in "Subscriber-related expenses" was primarily attributable to higher programming costs. The increase in programming costs was driven by rate increases in certain of our programming contracts, including the renewal of certain contracts at higher rates. During the fourth quarter 2012, $6 million of expenses related to the acquisition of broadband subscribers for the period beginning January 1, 2012 through September 30, 2012 that were previously included in "Subscriber-related expenses" were reclassified to "Subscriber acquisition costs." These amounts associated with our broadband services for 2011 were immaterial. "Subscriber-related expenses" represented 55.4% and 52.8% of "Subscriber-related revenue" during the year ended December 31, 2012 and 2011, respectively. The change in this expense to revenue ratio primarily resulted from higher programming costs, discussed above. In the normal course of business, we enter into contracts to purchase programming content in which our payment obligations are fully contingent on the number of subscribers to whom we provide the respective content. Our programming expenses will continue to increase to the extent we are successful in growing our subscriber base. In addition, our "Subscriber-related expenses" may face further upward pressure from price increases and the renewal of long-term programming contracts on less favorable pricing terms. Cost of sales - equipment, merchandise, services, rental and other. "Cost of sales - equipment, merchandise, services, rental and other" totaled $570 million for the year ended December 31, 2012, an increase of $121 million compared to the same period in 2011. This increase was primarily driven by a full year of expense in 2012 compared to approximately eight months in the previous year of rental title purchases or revenue sharing to studios, packaging and on-line delivery costs as well as the cost of merchandise sold such as movies, video games and other items related to our Blockbuster operations. In addition, our "Cost of sales - equipment, merchandise, services, rental and other" was adversely impacted by a charge of $21 million as a result of the Blockbuster UK Administration, and higher inventory costs per unit during the year ended December 31, 2012 compared to the fair value of the inventory costs per unit acquired in the Blockbuster Acquisition which were expensed during the prior period. See Note 10 in the Notes to the Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K for further discussion. These increases were partially offset by a decline in expense as a result of Blockbuster domestic store closings during 2012 and 2011. Blockbuster operations are included in our financial results beginning April 26, 2011. 67 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Subscriber acquisition costs. "Subscriber acquisition costs" totaled $1.687 billion for the year ended December 31, 2012, an increase of $182 million or 12.1% compared to the same period in 2011. This increase was primarily attributable to the increase in gross new subscriber activations and SAC described below. The $1.687 billion of subscriber acquisition costs includes $6 million of expenses related to our broadband services for the period beginning January 1, 2012 through September 30, 2012 that were previously included in "Subscriber-related expenses" and were reclassified to "Subscriber acquisition costs." These amounts associated with our broadband services for 2011 were immaterial. Pay-TV SAC. Pay-TV SAC was $784 during the year ended December 31, 2012 compared to $770 during the same period in 2011, an increase of $14 or 1.8%. This increase was primarily attributable to increased advertising associated with our Hopper set-top box. The following table details Pay-TV SAC by quarter for the year ended December 31, 2012. Pay-TV Pay-TV SAC SAC First Quarter, 2012 $ 747 Second Quarter, 2012 800 Third Quarter, 2012 797 Fourth Quarter, 2012 791 Year-to-date, 2012 784 During the years ended December 31, 2012 and 2011, the amount of equipment capitalized under our lease program for new Pay-TV subscribers totaled $506 million and $480 million, respectively. This increase in capital expenditures under our lease program for new Pay-TV subscribers resulted primarily from an increase in gross new Pay-TV subscribers. Capital expenditures resulting from our equipment lease program for new Pay-TV subscribers were partially mitigated by the redeployment of equipment returned by disconnecting lease program Pay-TV subscribers. To remain competitive we upgrade or replace subscriber equipment periodically as technology changes, and the costs associated with these upgrades may be substantial. To the extent technological changes render a portion of our existing equipment obsolete, we would be unable to redeploy all returned equipment and consequently would realize less benefit from the Pay-TV SAC reduction associated with redeployment of that returned lease equipment. Our Pay-TV SAC calculation does not reflect any benefit from payments we received in connection with equipment not returned to us from disconnecting lease subscribers and returned equipment that is made available for sale or used in our existing customer lease program rather than being redeployed through our new customer lease program. During the years ended December 31, 2012 and 2011, these amounts totaled $140 million and $96 million, respectively. We have been deploying receivers that utilize 8PSK modulation technology and receivers that utilize MPEG-4 compression technology for several years. These technologies, when fully deployed, will allow more programming channels to be carried over our existing satellites. Many of our customers today, however, do not have receivers that use MPEG-4 compression and a smaller but still significant number do not have receivers that use 8PSK modulation. We may choose to invest significant capital to accelerate the conversion of customers to MPEG-4 and/or 8PSK to realize the bandwidth benefits sooner. In addition, given that all of our HD content is broadcast in MPEG-4, any growth in HD penetration will naturally accelerate our transition to these newer technologies and may increase our subscriber acquisition and retention costs. All new receivers that we purchase from EchoStar have MPEG-4 technology. Although we continue to refurbish and redeploy MPEG-2 receivers, as a result of our HD initiatives and current promotions, we currently activate most new customers with higher priced MPEG-4 technology. This limits our ability to redeploy MPEG-2 receivers and, to the extent that our promotions are successful, will accelerate the transition to MPEG-4 technology, resulting in an adverse effect on our SAC. Our "Subscriber acquisition costs" and "Pay-TV SAC" may materially increase in the future to the extent that we transition to newer technologies, introduce more aggressive promotions, or provide greater equipment subsidies. See further discussion under "Other Liquidity Items - Subscriber Acquisition and Retention Costs." 68 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued General and administrative expenses. "General and administrative expenses" totaled $1.354 billion during the year ended December 31, 2012, a $119 million or 9.6% increase compared to the same period in 2011. This increase was primarily due to increased personnel and infrastructure expenses for DISH Network and the inclusion of twelve months of costs in 2012 for personnel, building and maintenance and other administrative costs associated with our Blockbuster operations compared to eight months during the previous year. Blockbuster operations are included in our financial results beginning April 26, 2011. Litigation expense. "Litigation expense" related to legal settlements, judgments or accruals associated with certain significant litigation totaled $730 million during the year ended December 31, 2012 related to the Voom Settlement Agreement. During the year ended December 31, 2011, "Litigation expense" totaled a negative $317 million. During the year ended December 31, 2011, we reversed $341 million related to the April 29, 2011 settlement agreement with TiVo, which was previously recorded as an expense. See Note 16 and Note 20 in the Notes to our Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K for further discussion. Depreciation and amortization. "Depreciation and amortization" expense totaled $983 million during the year ended December 31, 2012, a $61 million or 6.6% increase compared to the same period in 2011. This change in "Depreciation and amortization" expense was primarily due to $68 million of depreciation expense related to the 148 degree orbital location in 2012 and an increase in depreciation expense associated with additional assets which were placed in service to support DISH Network, partially offset by a decrease in depreciation expense on equipment leased to subscribers. See Note 8 in the Notes to the Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K for further discussion. Interest income. "Interest income" totaled $100 million during the year ended December 31, 2012, an increase of $65 million compared to the same period in 2011. This increase principally resulted from higher percentage returns earned on our cash and marketable investment securities and higher average cash and marketable investment securities balances during the year ended December 31, 2012. Interest expense, net of amounts capitalized. "Interest expense, net of amounts capitalized" totaled $537 million during the year ended December 31, 2012, a decrease of $21 million or 3.8% compared to the same period in 2011. This change primarily resulted from capitalized interest of $106 million related to our wireless spectrum, partially offset by the net interest expense associated with the issuances and redemption of our senior notes during 2012 and 2011. Other, net. "Other, net" income totaled $148 million during the year ended December 31, 2012, an increase of $142 million compared to the same period in 2011. This change primarily resulted from a $99 million non-cash gain related to the conversion of our DBSD North America 7.5% Convertible Senior Secured Notes due 2009 in connection with the completion of the DBSD Transaction during the first quarter 2012 and an increase in net gains on the sale of marketable investment securities of $96 million, partially offset by an increase in impairment charges of $32 million during 2012. In addition, this change was impacted by a $25 million impairment charge related to the Blockbuster UK Administration. See Note 6 and Note 10 in the Notes to the Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K for further discussion. 69 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Earnings before interest, taxes, depreciation and amortization. EBITDA was $2.364 billion during the year ended December 31, 2012, a decrease of $1.492 billion or 38.7% compared to the same period in 2011. EBITDA for year ended December 31, 2012 was unfavorably impacted by $730 million of litigation expense related to the Voom Settlement Agreement and an increase in "Subscriber-related expense." EBITDA for the year ended December 31, 2011 was favorably impacted by the reversal of $341 million of "Litigation expense" related to the April 29, 2011 settlement agreement with TiVo, which had been previously recorded as an expense prior to the first quarter 2011. The following table reconciles EBITDA to the accompanying financial statements. For the Years Ended December 31, 2012 2011 (In thousands) EBITDA $ 2,364,122 $ 3,856,542 Interest expense, net (437,357 ) (523,556 ) Income tax (provision) benefit, net (307,029 ) (895,006 ) Depreciation and amortization (983,049 ) (922,073 ) Net income (loss) attributable to DISH Network $ 636,687 $ 1,515,907 EBITDA is not a measure determined in accordance with accounting principles generally accepted in the United States ("GAAP") and should not be considered a substitute for operating income, net income or any other measure determined in accordance with GAAP. EBITDA is used as a measurement of operating efficiency and overall financial performance and we believe it to be a helpful measure for those evaluating companies in the pay-TV industry. Conceptually, EBITDA measures the amount of income generated each period that could be used to service debt, pay taxes and fund capital expenditures. EBITDA should not be considered in isolation or as a substitute for measures of performance prepared in accordance with GAAP. Income tax (provision) benefit, net. Our income tax provision was $307 million during the year ended December 31, 2012, a decrease of $588 million compared to the same period in 2011. The decrease in the provision was primarily related to the decrease in "Income (loss) before income taxes" and a decrease in our effective tax rate. Our effective tax rate was positively impacted by the change in our valuation allowances against certain deferred tax assets that are capital in nature. Net income (loss) attributable to DISH Network. "Net income (loss) attributable to DISH Network" was $637 million during the year ended December 31, 2012, a decrease of $879 million compared to $1.516 billion for the same period in 2011. The decrease was primarily attributable to the changes in revenue and expenses discussed above. 70 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Year Ended December 31, 2011 Compared to the Year Ended December 31, 2010. For the Years Ended December 31, Variance Statements of Operations Data 2011 2010 Amount % (In thousands) Revenue: Subscriber-related revenue $ 12,976,009 $ 12,543,794 $ 432,215 3.4 Equipment and merchandise sales, rental and other revenue 1,035,910 59,770 976,140 * Equipment sales, services and other revenue - EchoStar 36,474 37,180 (706 ) (1.9 ) Total revenue 14,048,393 12,640,744 1,407,649 11.1 Costs and Expenses: Subscriber-related expenses 6,845,611 6,676,145 169,466 2.5 % of Subscriber-related revenue 52.8 % 53.2 % Satellite and transmission expenses - EchoStar 441,541 418,358 23,183 5.5 % of Subscriber-related revenue 3.4 % 3.3 % Satellite and transmission expenses - Other 39,806 40,249 (443 ) (1.1 ) % of Subscriber-related revenue 0.3 % 0.3 % Cost of sales - equipment, merchandise, services, rental and other 448,686 76,406 372,280 * Subscriber acquisition costs 1,505,177 1,653,494 (148,317 ) (9.0 ) General and administrative expenses 1,234,494 625,843 608,651 97.3 % of Total revenue 8.8 % 5.0 % Litigation expense (316,949 ) 225,456 (542,405 ) * Depreciation and amortization 922,073 983,965 (61,892 ) (6.3 ) Total costs and expenses 11,120,439 10,699,916 420,523 3.9 Operating income (loss) 2,927,954 1,940,828 987,126 50.9 Other Income (Expense): Interest income 34,354 25,158 9,196 36.6 Interest expense, net of amounts capitalized (557,910 ) (454,777 ) (103,133 ) (22.7 ) Other, net 6,186 30,996 (24,810 ) (80.0 ) Total other income (expense) (517,370 ) (398,623 ) (118,747 ) (29.8 ) Income (loss) before income taxes 2,410,584 1,542,205 868,379 56.3 Income tax (provision) benefit, net (895,006 ) (557,473 ) (337,533 ) (60.5 ) Effective tax rate 37.1 % 36.1 % Net income (loss) 1,515,578 984,732 530,846 53.9 Less: Net income (loss) attributable to noncontrolling interest (329 ) 3 (332 ) * Net income (loss) attributable to DISH Network $ 1,515,907 $ 984,729 $ 531,178 53.9 Other Data: Pay-TV subscribers, as of period end (in millions) 13.967 14.133 (0.166 ) (1.2 ) Pay-TV subscriber additions, gross (in millions) 2.576 3.052 (0.476 ) (15.6 ) Pay-TV subscriber additions, net (in millions) (0.166 ) 0.033 (0.199 ) * Average monthly subscriber churn rate 1.63 % 1.76 % (0.13 )% (7.4 ) Average subscriber acquisition cost per subscriber ("SAC") $ 771 $ 776 $ (5 ) (0.6 ) Average monthly revenue per subscriber ("ARPU") $ 76.93 $ 73.32 $ 3.61 4.9 EBITDA $ 3,856,542 $ 2,955,786 $ 900,756 30.5 -------------------------------------------------------------------------------- * Percentage is not meaningful. 71 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Pay-TV subscribers. DISH lost approximately 166,000 net Pay-TV subscribers during the year ended December 31, 2011, compared to a gain of approximately 33,000 net new Pay-TV subscribers during the same period in 2010. The change versus the prior year primarily resulted from a decline in gross new Pay-TV subscriber activations. During the year ended December 31, 2011, DISH added approximately 2.576 million gross new Pay-TV subscribers compared to approximately 3.052 million gross new Pay-TV subscribers during the same period in 2010, a decrease of 15.6%. Our gross activations and net Pay-TV subscriber additions were negatively impacted during the year ended December 31, 2011 compared to the same period in 2010 as a result of increased competitive pressures, including aggressive marketing and the effectiveness of certain competitors' promotional offers, which included an increased level of programming discounts. In addition, telecommunications companies continue to grow their respective customer bases. Our gross activations and net Pay-TV subscriber additions continue to be adversely affected during the year ended December 31, 2011 by sustained economic weakness and uncertainty, including, among other things, the weak housing market in the United States combined with lower discretionary spending. Our Pay-TV churn rate for the year ended December 31, 2011 was 1.63%, compared to 1.76% for the same period in 2010. While our Pay-TV churn rate improved compared to the same period in 2010, our Pay-TV churn rate continues to be adversely affected by the increased competitive pressures discussed above. In general, our Pay-TV churn rate is impacted by the quality of Pay-TV subscribers acquired in past quarters, our ability to provide outstanding customer service, and our ability to control piracy. Subscriber-related revenue. DISH "Subscriber-related revenue" totaled $12.976 billion for the year ended December 31, 2011, an increase of $432 million or 3.4% compared to the same period in 2010. This change was primarily related to the increase in "ARPU" discussed below. ARPU. "Average monthly revenue per subscriber" was $76.93 during the year ended December 31, 2011 versus $73.32 during the same period in 2010. The $3.61 or 4.9% increase in ARPU was primarily attributable to price increases during the past year, higher hardware related revenue and fees earned from our in-home service operations, partially offset by decreases in premium and pay per view revenue. Equipment and merchandise sales, rental and other revenue. "Equipment and merchandise sales, rental and other revenue" totaled $1.036 billion for the year ended December 31, 2011, an increase of $976 million compared to the same period in 2010. This increase was primarily driven by revenue from the rental of movies and video games, the sale of previously rented titles, and other merchandise sold to customers including movies, video games and other accessories related to our Blockbuster operations which commenced April 26, 2011. Subscriber-related expenses. "Subscriber-related expenses" totaled $6.846 billion during the year ended December 31, 2011, an increase of $169 million or 2.5% compared to the same period in 2010. The increase in "Subscriber-related expenses" was primarily attributable to higher programming costs and an increase in customer retention expense, partially offset by reduced costs related to our call centers. The increase in programming costs was driven by rate increases in certain of our programming contracts, including the renewal of certain contracts at higher rates. "Subscriber-related expenses" represented 52.8% and 53.2% of "Subscriber-related revenue" during the year ended December 31, 2011 and 2010, respectively. The improvement in this expense to revenue ratio primarily resulted from an increase in "Subscriber-related revenue," partially offset by higher programming costs, discussed above. Cost of sales - equipment, merchandise, services, rental and other. "Cost of sales - equipment, merchandise, services, rental and other" totaled $449 million for the year ended December 31, 2011, an increase of $372 million compared to the same period in 2010. This increase is primarily associated with the cost of rental title purchases or revenue sharing to studios, packaging and on-line delivery costs as well as the cost of merchandise sold such as movies, video games and other accessories related to our Blockbuster operations which commenced April 26, 2011. Subscriber acquisition costs. "Subscriber acquisition costs" totaled $1.505 billion for the year ended December 31, 2011, a decrease of $148 million or 9.0% compared to the same period in 2010. This decrease was primarily attributable to a decline in gross new subscriber activations. 72 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued SAC. SAC was $771 during the year ended December 31, 2011 compared to $776 during the same period in 2010, a decrease of $5 or 0.6%. This decrease was primarily attributable to an increase in the percentage of redeployed receivers that were installed. During the years ended December 31, 2011 and 2010, the amount of equipment capitalized under our lease program for new subscribers totaled $480 million and $716 million, respectively. This decrease in capital expenditures under our lease program for new subscribers resulted primarily from a decrease in gross new subscriber activations and an increase in the percentage of redeployed receivers that were installed. Capital expenditures resulting from our equipment lease program for new subscribers were partially mitigated by the redeployment of equipment returned by disconnecting lease program subscribers. To remain competitive we upgrade or replace subscriber equipment periodically as technology changes, and the costs associated with these upgrades may be substantial. To the extent technological changes render a portion of our existing equipment obsolete, we would be unable to redeploy all returned equipment and consequently would realize less benefit from the SAC reduction associated with redeployment of that returned lease equipment. Our SAC calculation does not reflect any benefit from payments we received in connection with equipment not returned to us from disconnecting lease subscribers and returned equipment that is made available for sale or used in our existing customer lease program rather than being redeployed through our new customer lease program. During the years ended December 31, 2011 and 2010, these amounts totaled $96 million and $108 million, respectively. General and administrative expenses. "General and administrative expenses" totaled $1.234 billion during the year ended December 31, 2011, a $609 million increase compared to the same period in 2010. This increase was primarily due to an increase in personnel, building and maintenance and other administrative costs associated with our Blockbuster operations which commenced April 26, 2011. Litigation expense. "Litigation expense" totaled a negative $317 million during the year ended December 31, 2011, a reduction in expense of $542 million compared to the same period in 2010. See Note 20 in the Notes to our Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K for further discussion. Depreciation and amortization. "Depreciation and amortization" expense totaled $922 million during the year ended December 31, 2011, a $62 million or 6.3% decrease compared to the same period in 2010. This change in "Depreciation and amortization" expense was primarily due to a decrease in depreciation on equipment leased to subscribers principally related to less equipment capitalization during 2011 compared to the same period in 2010 and less equipment write-offs from disconnecting subscribers. This decrease was partially offset by an increase in depreciation on satellites as a result of EchoStar XIV and EchoStar XV being placed into service during the second and third quarters 2010, respectively. Interest expense, net of amounts capitalized. "Interest expense, net of amounts capitalized" totaled $558 million during the year ended December 31, 2011, an increase of $103 million or 22.7% compared to the same period in 2010. This change primarily resulted from an increase in interest expense related to the issuance of our 6 3/4% Senior Notes due 2021 during the second quarter 2011 and a decrease in the amount of interest capitalized, partially offset by a decrease in interest expense as a result of the repurchases and redemptions of our 6 3/8% Senior Notes due 2011. 73 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Earnings before interest, taxes, depreciation and amortization. EBITDA was $3.857 billion during the year ended December 31, 2011, an increase of $901 million or 30.5% compared to the same period in 2010. The following table reconciles EBITDA to the accompanying financial statements. For the Years Ended December 31, 2011 2010 (In thousands) EBITDA $ 3,856,542 $ 2,955,786 Interest expense, net (523,556 ) (429,619 ) Income tax (provision) benefit, net (895,006 ) (557,473 ) Depreciation and amortization (922,073 ) (983,965 ) Net income (loss) attributable to DISH Network $ 1,515,907 $ 984,729 EBITDA is not a measure determined in accordance with GAAP and should not be considered a substitute for operating income, net income or any other measure determined in accordance with GAAP. EBITDA is used as a measurement of operating efficiency and overall financial performance and we believe it to be a helpful measure for those evaluating companies in the pay-TV industry. Conceptually, EBITDA measures the amount of income generated each period that could be used to service debt, pay taxes and fund capital expenditures. EBITDA should not be considered in isolation or as a substitute for measures of performance prepared in accordance with GAAP. Income tax (provision) benefit, net. Our income tax provision was $895 million during the year ended December 31, 2011, an increase of $338 million compared to the same period in 2010. The increase in the provision was primarily related to the increase in "Income (loss) before income taxes." Net income (loss) attributable to DISH Network. "Net income (loss) attributable to DISH Network" was $1.516 billion during the year ended December 31, 2011, an increase of $531 million compared to $985 million for the same period in 2010. The increase was primarily attributable to the changes in revenue and expenses discussed above. LIQUIDITY AND CAPITAL RESOURCES Cash, Cash Equivalents and Current Marketable Investment Securities We consider all liquid investments purchased within 90 days of their maturity to be cash equivalents. See "Item 7A. - Quantitative and Qualitative Disclosures About Market Risk" for further discussion regarding our marketable investment securities. As of December 31, 2012, our cash, cash equivalents and current marketable investment securities totaled $7.238 billion compared to $2.041 billion as of December 31, 2011, an increase of $5.197 billion. This increase in cash, cash equivalents and current marketable investment securities was primarily related to cash generated from operations of $2.012 billion, the net proceeds of $4.387 billion related to the issuance of our long-term debt and an increase of $187 million in the value of certain marketable investment securities, partially offset by capital expenditures of $958 million and the $453 million dividend paid in cash on our Class A and Class B common stock. We have investments in various debt and equity instruments including corporate bonds, corporate equity securities, government bonds and variable rate demand notes ("VRDNs"). VRDNs are long-term floating rate municipal bonds with embedded put options that allow the bondholder to sell the security at par plus accrued interest. All of the put options are secured by a pledged liquidity source. Our VRDN portfolio is comprised mainly of investments in municipalities, which are backed by financial institutions or other highly rated obligors that serve as the pledged liquidity source. While they are classified as marketable investment securities, the put option allows VRDNs to be liquidated generally on a same day or on a five business day settlement basis. As of December 31, 2012 and 2011, we held VRDNs, within our current marketable investment securities portfolio, with fair values of $130 million and $161 million, respectively. 74 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued The following discussion highlights our cash flow activities during the years ended December 31, 2012, 2011 and 2010. Free Cash Flow We define free cash flow as "Net cash flows from operating activities" less "Purchases of property and equipment," as shown on our Consolidated Statements of Cash Flows. We believe free cash flow is an important liquidity metric because it measures, during a given period, the amount of cash generated that is available to repay debt obligations, make investments, fund acquisitions and for certain other activities. Free cash flow is not a measure determined in accordance with GAAP and should not be considered a substitute for "Operating income," "Net income," "Net cash flows from operating activities" or any other measure determined in accordance with GAAP. Since free cash flow includes investments in operating assets, we believe this non-GAAP liquidity measure is useful in addition to the most directly comparable GAAP measure "Net cash flows from operating activities." During the years ended December 31, 2012, 2011 and 2010, free cash flow was significantly impacted by changes in operating assets and liabilities and in "Purchases of property and equipment" as shown in the "Net cash flows from operating activities" and "Net cash flows from investing" sections, respectively, of our Consolidated Statements of Cash Flows included herein. Operating asset and liability balances can fluctuate significantly from period to period and there can be no assurance that free cash flow will not be negatively impacted by material changes in operating assets and liabilities in future periods, since these changes depend upon, among other things, management's timing of payments and control of inventory levels, and cash receipts. In addition to fluctuations resulting from changes in operating assets and liabilities, free cash flow can vary significantly from period to period depending upon, among other things, subscriber growth, subscriber revenue, subscriber churn, subscriber acquisition costs including amounts capitalized under our equipment lease programs, operating efficiencies, increases or decreases in purchases of property and equipment, and other factors. The following table reconciles free cash flow to "Net cash flows from operating activities." For the Years Ended December 31, 2012 2011 2010 (In thousands) Free cash flow $ 1,054,309 $ 1,794,973 $ 923,670 Add back: Purchases of property and equipment 957,566 778,905 1,216,132 Net cash flows from operating activities $ 2,011,875 $ 2,573,878 $ 2,139,802 The decrease in free cash flow from 2011 to 2012 of $741 million resulted from a decease in "Net cash flows from operating activities" of $562 million and an increase in "Purchases of property and equipment" of $179 million. The decrease in "Net cash flows from operating activities" was primarily attributable to a $1.271 billion decrease of net income adjusted to exclude non-cash charges for "Depreciation and amortization" expense, "Realized and unrealized losses (gains) on investments," and "Deferred tax expense (benefit)," which includes the negative impact of $676 million of payments for the Voom Settlement Agreement. See Note 16 in the Notes to our Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K. This decrease was partially offset by a $684 million increase in cash resulting from changes in operating assets and liabilities. The increase in cash resulting from changes in operating assets and liabilities is principally attributable to the unfavorable impact in 2011 of the settlement of the TiVo litigation and timing differences between book expense and tax payments. The increase in "Purchases of property and equipment" in 2012 was primarily attributable to an increase in satellite construction and other corporate capital expenditures. The increase in free cash flow from 2010 to 2011 of $871 million resulted from an increase in "Net cash flows from operating activities" of $434 million and a decrease in "Purchases of property and equipment" of $437 million. The increase in "Net cash flows from operating activities" was primarily attributable to a $895 million increase in cash resulting from net income, adjusted to exclude non-cash changes in "Deferred tax expense (benefit)," and "Depreciation and amortization" expense, partially offset by a $502 million decrease in cash resulting from changes in operating assets and liabilities. The decrease in cash resulting from changes in operating assets and liabilities is principally attributable to timing differences between book expense and cash payments and $350 million in payments for the TiVo and Retailer Class Action settlements. The decrease in "Purchases of property and equipment" in 2011 75 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued was primarily attributable to a decrease in satellite construction and a decline in expenditures for equipment under our lease programs for new and existing subscribers of $241 million. On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 was enacted, which provides for a bonus depreciation deduction of 100% of the cost of our qualified capital expenditures from September 8, 2010 through December 31, 2011. During the year ended December 31, 2011, our "Deferred income tax expense (benefit)" recorded as a non-cash adjustment to net income on our Consolidated Statements of Cash Flows increased $427 million compared to the same period in 2010. This change is primarily associated with equipment-related temporary differences as a result of bonus depreciation deductions available in 2011. Cash flows from operating activities. We typically reinvest the cash flow from operating activities in our business primarily to grow our subscriber base and to expand our infrastructure. For the years ended December 31, 2012, 2011 and 2010, we reported net cash flows from operating activities of $2.012 billion, $2.574 billion, and $2.140 billion, respectively. See discussion of changes in net cash flows from operating activities included in "Free cash flow" above. Cash flows from investing activities. Our investing activities generally include purchases and sales of marketable investment securities, acquisitions, strategic investments and cash used to grow our subscriber base and expand our infrastructure. For the years ended December 31, 2012, 2011 and 2010, we reported net cash outflows from investing activities of $3.019 billion, $2.695 billion and $1.478 billion, respectively. During the years ended December 31, 2012, 2011 and 2010, capital expenditures for new and existing pay-TV customer equipment totaled $703 million, $701 million and $942 million, respectively. During the year ended December 31, 2012, capital expenditures for new and existing broadband customer equipment totaled $24 million, of which $22 million was for new broadband customer equipment. During the years ended December 31, 2011 and 2010, capital expenditures for broadband customer equipment were immaterial. The increase in net cash outflows from investing activities from 2011 to 2012 of $324 million primarily related to net purchases of marketable investment securities of $2.728 billion and capital expenditures of $179 million, partially offset by a decrease in net purchases of strategic investments of $2.637 billion. The increase in capital expenditures included $37 million for satellites, $26 million associated with our pay-TV and broadband subscriber acquisition and retention lease programs and $116 million of other corporate capital expenditures. The decrease in net purchases of strategic investments primarily resulted from our 2011 investments in DBSD North America of $1.139 billion and in TerreStar of $1.345 billion. The increase in net cash outflows from investing activities from 2010 to 2011 of $1.218 billion primarily resulted from our investment in DBSD North America of $1.139 billion, the TerreStar Transaction of $1.345 billion, the Blockbuster Acquisition of $127 million, net of $107 million cash received, and the Sprint Settlement Agreement net payment of $114 million which were partially offset by a net increase in sales of marketable investment securities of $1.072 billion and a decline in capital expenditures of $437 million. Cash flows from financing activities. Our financing activities generally include net proceeds related to the issuance of long-term debt, cash used for the repurchase, redemption or payment of long-term debt and capital lease obligations, dividends paid on our Class A and Class B common stock and repurchases of our Class A common stock. For the years ended December 31, 2012 and 2011, we reported net cash inflows from financing activities of $4.002 billion and $94 million, respectively. For the year ended December 31, 2010, we reported net cash outflows from financing activities of $127 million. The net cash inflows in 2012 primarily related to the net proceeds of $4.387 billion related to the issuance of our 5 7/8% Senior Notes due 2022, our 4 5/8% Senior Notes due 2017 and our 5% Senior Notes due 2023, partially offset by the $453 million dividend paid in cash on our Class A and Class B common stock. The net cash inflows in 2011 primarily related to the proceeds of $1.973 billion from the issuance of our 6 3/4% Senior Notes due 2021, net of deferred financing costs, partially offset by the redemption and repurchases of our 6 3/8% Senior Notes due 2011 of $1.0 billion and our dividend payment of $893 million. The net cash outflows in 2010 primarily related to the repurchases of our Class A common stock. 76 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Other Liquidity Items Subscriber Base DISH added approximately 89,000 net Pay-TV subscribers during the year ended December 31, 2012, compared to a loss of approximately 166,000 net Pay-TV subscribers during the same period in 2011. The increase versus the same period in 2011 primarily resulted from a decrease in our average monthly Pay-TV subscriber churn rate and higher gross new Pay-TV subscriber activations due primarily to increased advertising associated with our Hopper set-top box. See "Results of Operations" above for further discussion. There are a number of factors that impact our future cash flow compared to the cash flow we generate at any given point in time, including our Pay-TV churn rate and how successful we are at retaining our current Pay-TV subscribers. As we lose Pay-TV subscribers from our existing base, the positive cash flow from that base is correspondingly reduced. Satellites Operation of our pay-TV service requires that we have adequate satellite transmission capacity for the programming we offer. Moreover, current competitive conditions require that we continue to expand our offering of new programming. While we generally have had in-orbit satellite capacity sufficient to transmit our existing channels and some backup capacity to recover the transmission of certain critical programming, our backup capacity is limited. In the event of a failure or loss of any of our satellites, we may need to acquire or lease additional satellite capacity or relocate one of our other satellites and use it as a replacement for the failed or lost satellite. Such a failure could result in a prolonged loss of critical programming or a significant delay in our plans to expand programming as necessary to remain competitive and cause us to expend a significant portion of our cash to acquire or lease additional satellite capacity. Security Systems Increases in theft of our signal or our competitors' signals could, in addition to reducing new subscriber activations, also cause subscriber churn to increase. We use Security Access Devices in our receiver systems to control access to authorized programming content. Our signal encryption has been compromised in the past and may be compromised in the future even though we continue to respond with significant investment in security measures, such as Security Access Device replacement programs and updates in security software, that are intended to make signal theft more difficult. It has been our prior experience that security measures may only be effective for short periods of time or not at all and that we remain susceptible to additional signal theft. During 2009, we completed the replacement of our Security Access Devices and re-secured our system. We expect additional future replacements of these devices will be necessary to keep our system secure. We cannot ensure that we will be successful in reducing or controlling theft of our programming content and we may incur additional costs in the future if our system's security is compromised. Stock Repurchases Our Board of Directors previously authorized the repurchase of up to $1.0 billion of our Class A common stock. On November 2, 2012, our Board of Directors extended this authorization such that we are currently authorized to repurchase up to $1.0 billion of outstanding shares of our Class A common stock through and including December 31, 2013. As of December 31, 2012, we may repurchase up to $1.0 billion under this plan. During the years ended December 31, 2012 and 2011, there were no repurchases of our Class A common stock. During the year ended December 31, 2010, we repurchased 6.0 million shares of our Class A common stock for $107 million in the aggregate. Subscriber Acquisition and Retention Costs We incur significant upfront costs to acquire subscribers, including advertising, retailer incentives, equipment subsidies, installation services, and new customer promotions. While we attempt to recoup these upfront costs over the lives of their subscription, there can be no assurance that we will. We employ business rules such as minimum credit requirements and we strive to provide outstanding customer service, to increase the likelihood of customers 77 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued keeping their DISH service over longer periods of time. Our subscriber acquisition costs may vary significantly from period to period. We incur significant costs to retain our existing customers, mostly by upgrading their equipment to HD and DVR receivers. As with our subscriber acquisition costs, our retention spending includes the cost of equipment and installation services. In certain circumstances, we also offer free programming and/or promotional pricing for limited periods for existing customers in exchange for a commitment to receive service for a minimum term. A component of our retention efforts includes the installation of equipment for customers who move. Our subscriber retention costs may vary significantly from period to period. Covenants and Restrictions Related to our Senior Notes The indentures related to our outstanding senior notes contain restrictive covenants that, among other things, impose limitations on the ability of DISH DBS and its restricted subsidiaries to: (i) incur additional indebtedness; (ii) enter into sale and leaseback transactions; (iii) pay dividends or make distributions on DISH DBS's capital stock or repurchase DISH DBS's capital stock; (iv) make certain investments; (v) create liens; (vi) enter into certain transactions with affiliates; (vii) merge or consolidate with another company; and (viii) transfer or sell assets. Should we fail to comply with these covenants, all or a portion of the debt under the senior notes could become immediately payable. The senior notes also provide that the debt may be required to be prepaid if certain change-in-control events occur. As of the date of filing of this Annual Report on Form 10-K, DISH DBS was in compliance with the covenants. Other We are also vulnerable to fraud, particularly in the acquisition of new subscribers. While we are addressing the impact of subscriber fraud through a number of actions, there can be no assurance that we will not continue to experience fraud, which could impact our subscriber growth and churn. Sustained economic weakness may create greater incentive for signal theft and subscriber fraud, which could lead to higher subscriber churn and reduced revenue. Obligations and Future Capital Requirements Contractual Obligations and Off-Balance Sheet Arrangements As of December 31, 2012, future maturities of our long-term debt, capital lease and contractual obligations are summarized as follows: Payments due by period Total 2013 2014 2015 2016 2017 Thereafter (In thousands) Long-term debt obligations $ 11,638,955 $ 508,186 $ 1,007,851 $ 758,232 $ 1,506,742 $ 906,975 $ 6,950,969 Capital lease obligations 249,145 29,515 26,672 27,339 30,024 32,958 102,637 Interest expense on long-term debt and capital lease obligations 4,918,951 774,373 732,260 634,705 549,420 493,257 1,734,936 Satellite-related obligations 2,259,436 355,154 321,479 301,109 253,144 242,777 785,773 Operating lease obligations (1) 245,630 85,482 51,499 32,055 22,878 8,541 45,175 Purchase obligations (1) 3,508,013 1,810,364 520,462 436,396 314,589 165,059 261,143 Total $ 22,820,130 $ 3,563,074 $ 2,660,223 $ 2,189,836 $ 2,676,797 $ 1,849,567 $ 9,880,633 -------------------------------------------------------------------------------- (1) Contractual obligations related to Blockbuster UK are not included above. Our Blockbuster UK Operating Entities entered into Administration in the United Kingdom on January 16, 2013, as discussed in Note 10 in the Notes to our Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K. In certain circumstances the dates on which we are obligated to make these payments could be delayed. These amounts will increase to the extent we procure insurance for our satellites or contract for the construction, launch or lease of additional satellites. 78 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued In addition, the table above does not include $347 million of liabilities associated with unrecognized tax benefits which were accrued, as discussed in Note 12 in the Notes to our Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K, and are included on our Consolidated Balance Sheets as of December 31, 2012. We do not expect any portion of this amount to be paid or settled within the next twelve months. Other than the "Guarantees" disclosed in Note 16 in the Notes to our Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K, we generally do not engage in off-balance sheet financing activities. Satellites Under Construction EchoStar XVIII On September 7, 2012, we entered into a contract with SS/L for the construction of EchoStar XVIII, a DBS satellite designed with spot beam technology for advanced television services such as HD programming. This satellite is expected to be launched during 2015. Future commitments related to this satellite are included in the table above under "Satellite related obligations," except where noted below. As of December 31, 2012, we had not procured a launch contract and launch insurance for this satellite; therefore, these costs are not included in our satellite-related obligations in the table above. Satellite Insurance We generally do not carry commercial insurance for any of the in-orbit satellites that we use, other than certain satellites leased from third parties. We generally do not use commercial insurance to mitigate the potential financial impact of launch or in-orbit failures because we believe that the cost of insurance premiums is uneconomical relative to the risk of such failures. While we generally have had in-orbit satellite capacity sufficient to transmit our existing channels and some backup capacity to recover the transmission of certain critical programming, our backup capacity is limited. In the event of a failure or loss of any of our satellites, we may need to acquire or lease additional satellite capacity or relocate one of our other satellites and use it as a replacement for the failed or lost satellite. Purchase Obligations Our 2013 purchase obligations primarily consist of binding purchase orders for receiver systems and related equipment, digital broadcast operations, satellite and transponder leases, engineering, and for products and services related to the operation of our DISH branded pay-TV service. Our purchase obligations also include certain guaranteed fixed contractual commitments to purchase programming content. Our purchase obligations can fluctuate significantly from period to period due to, among other things, management's control of inventory levels, and can materially impact our future operating asset and liability balances, and our future working capital requirements. Programming Contracts In the normal course of business, we enter into contracts to purchase programming content in which our payment obligations are fully contingent on the number of subscribers to whom we provide the respective content. These programming commitments are not included in the "Contractual obligations and off-balance sheet arrangements" table above. The terms of our contracts typically range from one to ten years with annual rate increases. Our programming expenses will continue to increase to the extent we are successful growing our subscriber base. In addition, our margins may face further downward pressure from price increases and the renewal of long term programming contracts on less favorable pricing terms. Future Capital Requirements We expect to fund our future working capital, capital expenditure and debt service requirements from cash generated from operations, existing cash and marketable investment securities balances, and cash generated through raising additional capital. The amount of capital required to fund our future working capital and capital expenditure needs varies, depending on, among other things, the rate at which we acquire new subscribers and the cost of subscriber acquisition and retention, including capitalized costs associated with our new and existing subscriber equipment 79 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued lease programs. The majority of our capital expenditures for 2013 are expected to be driven by the costs associated with subscriber premises equipment, included in our firm purchase obligations, as well as capital expenditures for our satellite-related obligations. These expenditures are necessary to operate and maintain our pay-TV service. Consequently, we consider them to be non-discretionary. The amount of capital required will also depend on the levels of investment necessary to support potential strategic initiatives, including our plans to expand our national HD offerings and other strategic opportunities that may arise from time to time. Our capital expenditures vary depending on the number of satellites leased or under construction at any point in time, and could increase materially as a result of increased competition, significant satellite failures, or sustained economic weakness. These factors could require that we raise additional capital in the future. Volatility in the financial markets has made it more difficult at times for issuers of high-yield indebtedness, such as us, to access capital markets at acceptable terms. These developments may have a significant effect on our cost of financing and our liquidity position. Wireless Spectrum On March 2, 2012, the FCC approved the transfer of 40 MHz of 2 GHz wireless spectrum licenses held by DBSD North America and TerreStar to us. On March 9, 2012, we completed the DBSD Transaction and the TerreStar Transaction, pursuant to which we acquired, among other things, certain satellite assets and wireless spectrum licenses held by DBSD North America and TerreStar. The total consideration to acquire these assets was approximately $2.860 billion. This amount includes $1.364 billion for the DBSD Transaction, $1.382 billion for the TerreStar Transaction, and the net payment of $114 million to Sprint pursuant to the Sprint Settlement Agreement. Our consolidated FCC applications for approval of the license transfers from DBSD North America and TerreStar were accompanied by requests for waiver of the FCC's Mobile Satellite Service ("MSS") "integrated service" and spare satellite requirements and various technical provisions. The FCC denied our requests for waiver of the integrated service and spare satellite requirements but did not initially act on our request for waiver of the various technical provisions. On March 21, 2012, the FCC released a Notice of Proposed Rule Making ("NPRM") proposing the elimination of the integrated service, spare satellite and various technical requirements attached to the 2 GHz licenses. On December 11, 2012, the FCC approved rules that eliminated these requirements and gave notice of its proposed modification of our 2 GHz authorizations to, among other things, allow us to offer single-mode terrestrial terminals to customers who do not desire satellite functionality. On February 15, 2013, the FCC issued an order, which will become effective on March 7, 2013, modifying our 2 GHz licenses to add terrestrial operating authority. The FCC's order of modification has imposed certain limitations on the use of a portion of this spectrum, including interference protections for other spectrum users and power and emission limits that we presently believe could render 5 MHz of our uplink spectrum effectively unusable for terrestrial services and limit our ability to fully utilize the remaining 15 MHz of our uplink spectrum for terrestrial services. These limitations could, among other things, impact the finalization of technical standards associated with our wireless business, and may have a material adverse effect on our ability to commercialize these licenses. The new rules also mandate certain interim and final build-out requirements for the licenses. By March 2017, we must provide terrestrial signal coverage and offer terrestrial service to at least 40% of the aggregate population represented by all of the areas covered by the licenses (the "2 GHz Interim Build-out Requirement"). By March 2020, we must provide terrestrial signal coverage and offer terrestrial service to at least 70% of the population in each area covered by an individual license (the "2 GHz Final Build-out Requirement"). If we fail to meet the 2 GHz Interim Build-out Requirement, the 2 GHz Final Build-out Requirement will be accelerated by one year, from March 2020 to March 2019. If we fail to meet the 2 GHz Final Build-out Requirement, our terrestrial authorization for each license area in which we fail to meet the requirement will terminate. In addition, the FCC is currently considering rules for a spectrum band that is adjacent to our 2 GHz licenses, known as the "H Block." If the FCC adopts rules for the H block that do not adequately protect our 2 GHz licenses, there could be a material adverse effect on our ability to commercialize the 2 GHz licenses. As a result of the completion of the DBSD Transaction and the TerreStar Transaction, we will likely be required to make significant additional investments or partner with others to, among other things, finance the commercialization and build-out requirements of these licenses and our integration efforts including compliance with regulations applicable to the acquired licenses. Depending on the nature and scope of such commercialization, build-out, and 80 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued integration efforts, any such investment or partnership could vary significantly. Additionally, recent consolidation in the wireless telecommunications industry, may, among other things, limit our available options, including our ability to partner with others. There can be no assurance that we will be able to develop and implement a business model that will realize a return on these spectrum licenses or that we will be able to profitably deploy the assets represented by these spectrum licenses, which may affect the carrying value of these assets and our future financial condition or results of operations. In 2008, we paid $712 million to acquire certain 700 MHz wireless spectrum licenses, which were granted to us by the FCC in February 2009. These licenses mandate certain interim and final build-out requirements. By June 2013, we must provide signal coverage and offer service to at least 35% of the geographic area in each area covered by each individual license (the "700 MHz Interim Build-out Requirement"). By the end of our license term (June 2019), we must provide signal coverage and offer service to at least 70% of the geographic area in each area covered by each individual license (the "700 MHz Final Build-out Requirement"). We have recently notified the FCC of our plans to commence signal coverage in select cities within certain of these areas, but we have not yet developed plans for providing signal coverage and offering service in all of these areas. If we fail to meet the 700 MHz Interim Build-out Requirement, the term of our licenses will be reduced, from June 2019 to June 2017, and we could face possible fines and the reduction of license area(s). If we fail to meet the 700 MHz Final Build-out Requirement, our authorization for each license area in which we fail to meet the requirement will terminate. To commercialize these licenses and satisfy the associated FCC build-out requirements, we will be required to make significant additional investments or partner with others. Depending on the nature and scope of such commercialization and build-out, any such investment or partnership could vary significantly. We have recently been engaged in discussions regarding a potential strategic transaction with Clearwire. On January 8, 2013, Clearwire issued a press release summarizing the proposed transaction at that time. Later that day, we confirmed that we had formally approached Clearwire with respect to a potential strategic transaction on the terms and conditions generally outlined in Clearwire's press release. The terms and conditions for a potential strategic transaction at that time disclosed by Clearwire generally provided for the following, among others: (i) we would acquire approximately 24% of Clearwire's total spectrum, for approximately $2.2 billion; and (ii) we would make an offer to purchase up to all of Clearwire's outstanding shares at a price of $3.30 per share in cash. This offer would be subject to certain conditions, including that we acquire no less than 25% of the fully-diluted shares of Clearwire and receive certain governance and minority protection rights. There is no assurance that we will continue discussions with Clearwire or that we will ultimately be able to conclude a transaction with Clearwire upon the terms outlined above or at all. To the extent that we are able to conclude a transaction with Clearwire, we may be required to commit a significant portion of our cash and marketable securities to fund these arrangements, and these commitments may cause us to defer or curtail investments in our core business, strategic investments, share repurchases or other transactions that we otherwise may have made. Furthermore, Clearwire has experienced significant operating and financial challenges in its recent history. Therefore, any investment we may make in Clearwire will be speculative, and we may lose all of the investment. In addition, we may be required to spend additional capital or raise additional capital to support an investment in Clearwire's business and to build out a network to utilize the spectrum acquired, which may not be available on acceptable terms or at all. There can be no assurance that we will be able to develop and implement a business model that will realize a return on a possible transaction with Clearwire or that we will be able to profitably deploy the spectrum assets, which may affect the carrying value of these assets and our future financial condition or results of operations. If we are unable to successfully address these challenges and risks, our business, financial condition or results of operations will likely suffer. Critical Accounting Estimates The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates, judgments and assumptions that affect amounts reported therein. Management bases its estimates, judgments and assumptions on historical experience and on various other factors that are believed to be reasonable under the circumstances. Actual results may differ from previously estimated amounts, and such differences may be material to the Consolidated Financial Statements. Estimates and assumptions are reviewed periodically, and the effects of revisions are reflected prospectively in the period they occur. The following represent what we believe are the critical accounting policies that may involve a high degree of estimation, judgment and complexity. For a summary 81 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued of our significant accounting policies, including those discussed below, see Note 2 in the Notes to our Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K. † Capitalized satellite receivers. Since we retain ownership of certain equipment provided pursuant to our subscriber equipment lease programs, we capitalize and depreciate equipment costs that would otherwise be expensed at the time of sale. Such capitalized costs are depreciated over the estimated useful life of the equipment, which is based on, among other things, management's judgment of the risk of technological obsolescence. Because of the inherent difficulty of making this estimate, the estimated useful life of capitalized equipment may change based on, among other things, historical experience and changes in technology as well as our response to competitive conditions. Changes in estimated useful life may impact "Depreciation and amortization" on our Consolidated Statements of Operations and Comprehensive Income (Loss). For example, if we had decreased the estimated useful life of our capitalized subscriber equipment by one year, annual 2012 depreciation expense would have increased by approximately $84 million. † Accounting for investments in private and publicly-traded securities. We hold debt and equity interests in companies, some of which are publicly traded and have highly volatile prices. We record an investment impairment charge in "Other, net" within "Other Income (Expense)" on our Consolidated Statements of Operations and Comprehensive Income (Loss) when we believe an investment has experienced a decline in value that is judged to be other-than-temporary. We monitor our investments for impairment by considering current factors including economic environment, market conditions and the operational performance and other specific factors relating to the business underlying the investment. Future adverse changes in these factors could result in losses or an inability to recover the carrying value of the investments that may not be reflected in an investment's current carrying value, thereby possibly requiring an impairment charge in the future. † Fair value of financial instruments. Fair value estimates of our financial instruments are made at a point in time, based on relevant market data as well as the best information available about the financial instrument. Sustained economic weakness has resulted in inactive markets for certain of our financial instruments, including our Auction Rate Securities ("ARS") and other investment securities. For certain of these instruments, there is no or limited observable market data. Fair value estimates for financial instruments for which no or limited observable market data is available are based on judgments regarding current economic conditions, liquidity discounts, currency, credit and interest rate risks, loss experience and other factors. These estimates involve significant uncertainties and judgments and may be a less precise measurement of fair value as compared to financial instruments where observable market data is available. We make certain assumptions related to expected maturity date, credit and interest rate risk based upon market conditions and prior experience. As a result, such calculated fair value estimates may not be realizable in a current sale or immediate settlement of the instrument. In addition, changes in the underlying assumptions used in the fair value measurement technique, including liquidity risks, and estimate of future cash flows, could significantly affect these fair value estimates, which could have a material adverse impact on our financial position and results of operations. For example, as of December 31, 2012, we held $106 million of securities that lack observable market quotes, and a 10% decrease in our estimated fair value of these securities would result in a decrease of the reported amount by approximately $11 million. † Valuation of long-lived assets. We evaluate the carrying value of long-lived assets to be held and used, other than goodwill and intangible assets with indefinite lives, when events and circumstances warrant such a review. We evaluate our DBS satellite fleet for recoverability as one asset group. See Note 2 in the Notes to our Consolidated Financial Statements in Item 15 of this Annual Report on Form 10-K. The carrying value of a long-lived asset or asset group is considered impaired when the anticipated undiscounted cash flows from such asset or asset group is less than its carrying value. In that event, a loss will be recorded in a new line item entitled "Impairments of indefinite-lived and long-lived assets" on our Consolidated Statements of Operations and Comprehensive Income (Loss) based on the amount by which the carrying value exceeds the fair value of the long-lived asset or asset group. Fair value is determined primarily using the estimated cash flows associated with the asset or asset group under review, discounted at a rate commensurate with the risk involved. Losses on long-lived assets to be disposed of by sale are determined in a similar manner, except that fair values are reduced for estimated selling costs. Among other reasons, changes in estimates of future cash flows could result in a write-down of the asset in a future period. 82 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued † Valuation of intangible assets with indefinite lives. We evaluate the carrying value of intangible assets with indefinite lives annually, and also when events and circumstances warrant. We use estimates of fair value to determine the amount of impairment, if any, of recorded intangible assets with indefinite lives. Fair value is determined using the estimated future cash flows, discounted at a rate commensurate with the risk involved or the market approach. While our impairment tests in 2012 indicated the fair value of our intangible assets exceeded their carrying amounts, significant changes in our estimates of future cash flows or market data could result in a write-down of intangible assets with indefinite lives in a future period, which will be recorded in a new line item entitled "Impairments of indefinite-lived and long-lived assets," on our Consolidated Statements of Operations and Comprehensive Income (Loss) and could be material to our consolidated results of operations and financial position. Based on the methodology utilized to test for impairment a 10% decrease in the estimated future cash flows or market value of comparable assets and/or, a 10% increase in the discount rate used in estimating the fair value of these assets (while all other assumptions remain unchanged) would not result in these assets being impaired. † Income taxes. Our income tax policy is to record the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in the accompanying consolidated balance sheets, as well as operating loss and tax credit carryforwards. Determining necessary valuation allowances requires us to make assessments about the timing of future events, including the probability of expected future taxable income and available tax planning opportunities. We periodically evaluate our need for a valuation allowance based on both historical evidence, including trends, and future expectations in each reporting period. Any such valuation allowance is recorded in either "Income tax (provision) benefit, net" on our Consolidated Statements of Operations and Comprehensive Income (Loss) or "Accumulated other comprehensive income (loss)" within "Stockholders' equity (deficit)" on our Consolidated Balance Sheets. Future performance could have a significant effect on the realization of tax benefits, or reversals of valuation allowances, as reported in our consolidated results of operations. † Uncertainty in tax positions. Management evaluates the recognition and measurement of uncertain tax positions based on applicable tax law, regulations, case law, administrative rulings and pronouncements and the facts and circumstances surrounding the tax position. Changes in our estimates related to the recognition and measurement of the amount recorded for uncertain tax positions could result in significant changes in our "Income tax provision (benefit), net," which could be material to our consolidated results of operations. † Contingent liabilities. A significant amount of management judgment is required in determining when, or if, an accrual should be recorded for a contingency and the amount of such accrual. Estimates generally are developed in consultation with counsel and are based on an analysis of potential outcomes. Due to the uncertainty of determining the likelihood of a future event occurring and the potential financial statement impact of such an event, it is possible that upon further development or resolution of a contingent matter, a charge could be recorded in a future period to "General and administrative expenses" or "Litigation expense" on our Consolidated Statements of Operations and Comprehensive Income (Loss) that would be material to our consolidated results of operations and financial position. † Business combinations. When we acquire a business, we allocate the purchase price to the various components of the acquisition based upon the fair value of each component using various valuation techniques, including the market approach, income approach and/or cost approach. The accounting standard for business combinations requires most identifiable assets, liabilities, noncontrolling interests and goodwill acquired to be recorded at estimated fair value. Determining the fair value of assets acquired and liabilities assumed requires management's judgment and often involves the use of significant estimates and assumptions, including assumptions with respect to the estimated future cash flows, discounted at a rate commensurate with the risk involved or the market approach. 83 -------------------------------------------------------------------------------- Table of Contents Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - Continued Seasonality Historically, the first half of the year generally produces fewer gross new subscriber activations than the second half of the year, as is typical in the pay-TV service industry. In addition, the first and fourth quarter generally produce a lower churn rate than the second and third quarter. However, we cannot provide assurance that this will continue in the future. Inflation Inflation has not materially affected our operations during the past three years. We believe that our ability to increase the prices charged for our products and services in future periods will depend primarily on competitive pressures. Backlog We do not have any material backlog of our products. 84 -------------------------------------------------------------------------------- Table of Contents |