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DISH DBS CORP - 10-Q - MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following narrative analysis of our results of operations together with the condensed consolidated financial statements and notes to the financial statements included elsewhere in this quarterly report. This management's narrative 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 our Annual Report on Form 10-K for the year ended December 31, 2012 and this Quarterly Report on Form 10-Q under the caption "Item 1A. Risk Factors." EXECUTIVE SUMMARY Overview DISH added approximately 36,000 net Pay-TV subscribers during the three months ended March 31, 2013, compared to the addition of approximately 104,000 net Pay-TV subscribers during the same period in 2012. The decrease versus the same period in 2012 primarily resulted from an increase in our Pay-TV churn rate and lower gross new Pay-TV subscriber activations. Our Pay-TV churn rate for the three months ended March 31, 2013 was 1.47% compared to 1.35% for the same period in 2012. Our Pay-TV churn rate was negatively impacted in part because we had a programming package price increase in the first quarter 2013 and did not during the same period in 2012. Churn continues to be adversely affected by the increased competitive pressures discussed below. Our Pay-TV 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. During the three months ended March 31, 2013, DISH added approximately 654,000 gross new Pay-TV subscribers compared to the addition of approximately 673,000 gross new Pay-TV subscribers during the same period in 2012, a decrease of 2.8%. 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. "Net income (loss)" for the three months ended March 31, 2013 was $206 million compared to $277 million for the same period in 2012. During the three months ended March 31, 2013, "Net income (loss)" decreased primarily due to an increase in subscriber-related expenses and subscriber acquisition costs, partially offset by the programming package price increase in February 2013. Our ability to compete successfully will depend on our ability to continue to obtain desirable programming and deliver it to our subscribers at competitive prices, among other things. 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 34 -------------------------------------------------------------------------------- Table of Contents Item 2. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS - Continued 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 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 a consumer can use, at his or her option, to view recorded programming in HD in multiple rooms. 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 that a consumer can use, at his or her option, 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 Pay-TV subscriber activations. 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 35 -------------------------------------------------------------------------------- Table of Contents Item 2. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS - Continued copyrights. Subsequently, Fox has alleged that the Sling placeshifting functionality and Hopper Transfers™ feature of our second generation Hopper set-top-box infringe its 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 8 in the Notes to our Condensed Consolidated Financial Statements for further information. 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 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. 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 4 1/4% Senior Notes due 2018 On April 5, 2013, we issued $1.2 billion aggregate principal amount of our five-year, 4 1/4% Senior Notes due April 1, 2018 at an issue price of 100.0%. Interest accrues at an annual rate of 4 1/4% and is payable semi-annually in cash, in arrears on April 1 and October 1 of each year, commencing on October 1, 2013. 5 1/8% Senior Notes due 2020 On April 5, 2013, we issued $1.1 billion aggregate principal amount of our seven-year, 5 1/8% Senior Notes due May 1, 2020 at an issue price of 100.0%. Interest accrues at an annual rate of 5 1/8% and is payable semi-annually in cash, in arrears on May 1 and November 1 of each year, commencing on November 1, 2013. 36 -------------------------------------------------------------------------------- Table of Contents Item 2. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS - Continued 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 DISH Network. On March 9, 2012, DISH Network completed the acquisitions of 100% of the equity of reorganized DBSD North America (the "DBSD Transaction") and substantially all of the assets of TerreStar (the "TerreStar Transaction"), pursuant to which DISH Network acquired, among other things, certain satellite assets and wireless spectrum licenses held by DBSD North America and TerreStar. The total consideration to acquire the DBSD North America and TerreStar assets was approximately $2.860 billion. On February 15, 2013, the FCC issued an order, which became effective on March 7, 2013, modifying DISH Network's 2 GHz licenses to expand its 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 DISH Network presently believes could render 5 MHz of its uplink spectrum effectively unusable for terrestrial services and limit its ability to fully utilize the remaining 15 MHz of its uplink spectrum for terrestrial services. These limitations could, among other things, impact the ongoing development of technical standards associated with DISH Network's wireless business, and may have a material adverse effect on DISH Network's ability to commercialize these licenses. The new rules also mandate certain interim and final build-out requirements for the licenses. By March 2017, DISH Network 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, DISH Network 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 DISH Network fails 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 DISH Network fails to meet the 2 GHz Final Build-out Requirement, DISH Network's terrestrial authorization for each license area in which it fails to meet the requirement will terminate. In addition, the FCC is currently considering rules for a spectrum band that is adjacent to DISH Network's 2 GHz licenses, known as the "H Block." If the FCC adopts rules for the H block that do not adequately protect DISH Network's 2 GHz licenses, there could be a material adverse effect on DISH Network's ability to commercialize the 2 GHz licenses. DISH Network 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 DISH Network's 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. We have made cash distributions to DISH Network to finance these acquisitions and may make additional cash distributions to, among other things, finance the commercialization and build-out of these licenses and DISH Network's integration efforts including compliance with regulations applicable to the acquired licenses. Additionally, recent consolidation in the wireless telecommunications industry, may, among other things, limit DISH Network's available options, including DISH Network's ability to partner with others. There can be no assurance that DISH Network will be able to develop and implement a business model that will realize a return on these spectrum licenses or that DISH Network will be able to profitably deploy the assets represented by these spectrum licenses. In 2008, DISH Network paid $712 million to acquire certain 700 MHz wireless spectrum licenses, which were granted to DISH Network by the FCC in February 2009. These licenses mandate certain interim and final build-out requirements. By June 2013, DISH Network 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 DISH Network's license term (June 2019), DISH Network 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"). DISH Network recently notified the FCC of its plans to commence signal coverage in select cities within certain of these areas, but DISH Network has not yet developed plans for providing signal coverage and offering service in all of these areas. If DISH Network fails to meet the 700 MHz Interim Build-out 37 -------------------------------------------------------------------------------- Table of Contents Item 2. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS - Continued Requirement, the term of DISH Network's licenses will be reduced, from June 2019 to June 2017, and DISH Network could face possible fines and the reduction of license area(s). If DISH Network fails to meet the 700 MHz Final Build-out Requirement, DISH Network's authorization for each license area in which it fails to meet the requirement will terminate. To commercialize these licenses and satisfy the associated FCC build-out requirements, DISH Network 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 may make cash distributions to, among other things, finance the commercialization and build-out of these licenses. There can be no assurance that DISH Network will be able to develop and implement a business model that will realize a return on these investments and profitably deploy the spectrum associated with the 700 MHz licenses. Sprint Merger Proposal On April 15, 2013, DISH Network announced that it had submitted a merger proposal to the Board of Directors of Sprint Nextel Corporation ("Sprint") for a total consideration of $25.5 billion, consisting of $17.3 billion in cash and $8.2 billion in stock. Under this proposal, Sprint shareholders would receive $7.00 per share, based upon the closing price of DISH Network shares on April 12, 2013, consisting of $4.76 per share in cash and 0.05953 DISH Network shares per Sprint share. The equity portion would represent approximately 32% ownership in the combined DISH Network/Sprint. There is no assurance that DISH Network's proposal will be accepted by Sprint or that DISH Network will ultimately be able to complete a transaction with Sprint upon terms acceptable to DISH Network. The proposed merger would be subject to, among other things, certain regulatory approvals, approval by Sprint's shareholders, and other customary closing conditions. To the extent that DISH Network completes the proposed merger with Sprint, it will be required to commit a majority of its cash and marketable securities, and it will incur significant additional indebtedness, including indebtedness incurred by us to finance the cash consideration and possibly to refinance certain existing debt. These commitments may cause DISH Network and us to defer or curtail other strategic investments, investments in our pay-TV business or other transactions. The incurrence of indebtedness to finance the proposed merger with Sprint, together with Sprint's existing indebtedness, will increase the leverage of the combined company. In addition, DISH Network may be required to spend additional capital or raise additional capital to support DISH Network's investment in Sprint's business and to continue the build-out of a wireless network, which may not be available on acceptable terms. We may raise additional indebtedness and make cash distributions to DISH Network to, among other things, finance the proposed merger with Sprint and to support DISH Network's investment in Sprint's business. There can be no assurance that DISH Network will be able to achieve its business and financial goals following the proposed merger with Sprint or that achievement of these goals will benefit us. If DISH Network is unable to successfully address these challenges and risks, among others, our business, financial condition and/or results of operations may suffer. For additional information, see Item 1A, "Risk Factors - Risks Relating to DISH Network's Proposed Merger with Sprint." Clearwire Proposal On January 8, 2013, Clearwire Corporation ("Clearwire") issued a press release summarizing a strategic transaction that DISH Network had proposed at that time. Later that day, DISH Network confirmed that it 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 disclosed by Clearwire generally provided for the following, among other things: (i) DISH Network would acquire approximately 24% of Clearwire's total spectrum, for approximately $2.2 billion; and (ii) DISH Network 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 DISH Network 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 DISH Network will continue discussions with Clearwire or that DISH Network will ultimately be able to complete a transaction with Clearwire upon the terms outlined above or at all. In connection with DISH Network's merger proposal for Sprint, DISH Network has stated that it expects Sprint's pending merger with Clearwire to be completed if DISH Network's proposal is accepted. 38 -------------------------------------------------------------------------------- Table of Contents Item 2. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS - Continued 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 our ability to: (i) incur additional indebtedness; (ii) enter into sale and leaseback transactions; (iii) pay dividends or make distributions on our capital stock or repurchase our 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, we were in compliance with the covenants. 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. On October 1, 2012, the assets and liabilities associated with our satellite broadband business were distributed to DISH Network. As a result, beginning in the fourth quarter 2012, we no longer have revenue related to a satellite broadband business. See Note 10 in the Notes to the Condensed Consolidated Financial Statements for further discussion. Equipment sales and other revenue. "Equipment sales 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. 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. On October 1, 2012, the assets and liabilities associated with our satellite broadband business were distributed to DISH Network. As a result, beginning in the fourth quarter 2012, we no longer have costs related to a satellite broadband business. See Note 10 in the Notes to the Condensed Consolidated Financial Statements for further discussion. 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. Cost of sales - equipment, services and other. "Cost of sales - equipment, services 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. In addition, this category includes costs related to equipment sales, services, and other agreements with EchoStar. 39 -------------------------------------------------------------------------------- Table of Contents Item 2. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS - Continued 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. We exclude the value of equipment capitalized under our lease program for new Pay-TV and broadband subscribers from "Subscriber acquisition costs." On October 1, 2012, the assets and liabilities associated with our satellite broadband business were distributed to DISH Network. As a result, beginning in the fourth quarter 2012, we no longer have costs related to a satellite broadband business. See Note 10 in the Notes to the Condensed Consolidated Financial Statements for further discussion. 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. 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 of investments, impairment of marketable and non-marketable investment securities, unrealized gains and losses from changes in fair value of marketable and non-marketable 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)" 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)" 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. 40 -------------------------------------------------------------------------------- Table of Contents Item 2. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS - Continued 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 Pay-TV 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. 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 churn rate, the same methodology for calculating average number of Pay-TV subscribers is used as when calculating Pay-TV ARPU. 41 -------------------------------------------------------------------------------- Table of Contents Item 2. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS - Continued RESULTS OF OPERATIONS Three Months Ended March 31, 2013 Compared to the Three Months Ended March 31, 2012. For the Three Months Ended March 31, Variance Statements of Operations Data 2013 2012 Amount % (In thousands) Revenue: Subscriber-related revenue $ 3,310,355 $ 3,218,946 $ 91,409 2.8 Equipment sales and other revenue 24,618 21,613 3,005 13.9 Equipment sales, services and other revenue - EchoStar 1,285 6,667 (5,382 ) (80.7 ) Total revenue 3,336,258 3,247,226 89,032 2.7 Costs and Expenses: Subscriber-related expenses 1,887,593 1,762,934 124,659 7.1 % of Subscriber-related revenue 57.0 % 54.8 % Satellite and transmission expenses - EchoStar 110,993 109,121 1,872 1.7 % of Subscriber-related revenue 3.4 % 3.4 % Satellite and transmission expenses - Other 9,981 10,574 (593 ) (5.6 ) % of Subscriber-related revenue 0.3 % 0.3 % Cost of sales - equipment, services and other 19,996 22,948 (2,952 ) (12.9 ) Subscriber acquisition costs 429,718 399,220 30,498 7.6 General and administrative expenses 158,368 171,164 (12,796 ) (7.5 ) % of Total revenue 4.7 % 5.3 % Depreciation and amortization 205,496 197,295 8,201 4.2 Total costs and expenses 2,822,145 2,673,256 148,889 5.6 Operating income (loss) 514,113 573,970 (59,857 ) (10.4 ) Other Income (Expense): Interest income 7,208 1,692 5,516 * Interest expense, net of amounts capitalized (195,766 ) (134,286 ) (61,480 ) (45.8 ) Other, net 128 2,705 (2,577 ) (95.3 ) Total other income (expense) (188,430 ) (129,889 ) (58,541 ) (45.1 ) Income (loss) before income taxes 325,683 444,081 (118,398 ) (26.7 ) Income tax (provision) benefit, net (119,452 ) (166,591 ) 47,139 28.3 Effective tax rate 36.7 % 37.5 % Net income (loss) $ 206,231 $ 277,490 $ (71,259 ) (25.7 ) Other Data: Pay-TV subscribers, as of period end (in millions) 14.092 14.071 0.021 0.1 Pay-TV subscriber additions, gross (in millions) 0.654 0.673 (0.019 ) (2.8 ) Pay-TV subscriber additions, net (in millions) 0.036 0.104 (0.068 ) (65.4 ) Pay-TV average monthly subscriber churn rate 1.47 % 1.35 % 0.12 % 8.9 Pay-TV average subscriber acquisition cost per subscriber ("Pay-TV SAC") $ 882 $ 747 $ 135 18.1 Pay-TV average monthly revenue per subscriber ("Pay-TV ARPU") $ 78.54 $ 76.24 $ 2.30 3.0 EBITDA (in thousands) $ 719,737 $ 773,970 $ (54,233 ) (7.0 ) -------------------------------------------------------------------------------- * Percentage is not meaningful. 42 -------------------------------------------------------------------------------- Table of Contents Item 2. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS - Continued Pay-TV subscribers. DISH added approximately 36,000 net Pay-TV subscribers during the three months ended March 31, 2013, compared to the addition of approximately 104,000 net Pay-TV subscribers during the same period in 2012. The decrease versus the same period in 2012 primarily resulted from an increase in our Pay-TV churn rate and lower gross new Pay-TV subscriber activations. Our Pay-TV churn rate for the three months ended March 31, 2013 was 1.47% compared to 1.35% for the same period in 2012. Our Pay-TV churn rate was negatively impacted in part because we had a programming package price increase in the first quarter 2013 and did not during the same period in 2012. Churn continues to be adversely affected by the increased competitive pressures discussed below. Our Pay-TV 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. During the three months ended March 31, 2013, DISH added approximately 654,000 gross new Pay-TV subscribers compared to the addition of approximately 673,000 gross new Pay-TV subscribers during the same period in 2012, a decrease of 2.8%. 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. 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. Subscriber-related revenue. "Subscriber-related revenue" totaled $3.310 billion for the three months ended March 31, 2013, an increase of $91 million or 2.8% compared to the same period in 2012. The change in "Subscriber-related revenue" from the same period in 2012 was primarily related to the increase in Pay-TV ARPU discussed below. On October 1, 2012, the assets and liabilities associated with our satellite broadband business were distributed to DISH Network. As a result, beginning in the fourth quarter 2012, we no longer have revenue related to a satellite broadband business. Included in Subscriber-related revenue" is $17 million of revenue related to broadband services for the three months ended March 31, 2012. See Note 10 in the Notes to the Condensed Consolidated Financial Statements for further discussion. Pay-TV ARPU. "Pay-TV average monthly revenue per subscriber" was $78.54 during the three months ended March 31, 2013 versus $76.24 during the same period in 2012. The $2.30 or 3.0% increase in Pay-TV ARPU was primarily attributable to the programming package price increase in February 2013 and higher hardware related revenue. Subscriber-related expenses. "Subscriber-related expenses" totaled $1.888 billion during the three months ended March 31, 2013, an increase of $125 million or 7.1% compared to the same period in 2012. The increase in "Subscriber-related expenses" was primarily attributable to higher pay-TV programming and retention 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. "Subscriber-related expenses" represented 57.0% and 54.8% of "Subscriber-related revenue" during the three months ended March 31, 2013 and 2012, respectively. The change in this expense to revenue ratio primarily resulted from higher programming costs, discussed above. On October 1, 2012, the assets and liabilities associated with our satellite broadband business were distributed to DISH Network. As a result, beginning in the fourth quarter 2012, we no longer have costs related to a satellite broadband business. Included in "Subscriber-related expenses" is $8 million of costs related to our broadband services for the three months ended March 31, 2012. See Note 10 in the Notes to the Condensed Consolidated Financial Statements for further discussion. 43 -------------------------------------------------------------------------------- Table of Contents Item 2. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS - Continued 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. Subscriber acquisition costs. "Subscriber acquisition costs" totaled $430 million for the three months ended March 31, 2013, an increase of $30 million or 7.6% compared to the same period in 2012. This increase was primarily attributable to the increase in gross new subscriber activations and SAC described below. On October 1, 2012, the assets and liabilities associated with our satellite broadband business were distributed to DISH Network. As a result, beginning in the fourth quarter 2012, we no longer have costs related to a satellite broadband business. Included in "Subscriber acquisition costs" is $4 million of costs related to our broadband services for the three months ended March 31, 2012. See Note 10 in the Notes to the Condensed Consolidated Financial Statements for further discussion. Pay-TV SAC. Pay-TV SAC was $882 during the three months ended March 31, 2013 compared to $747 during the same period in 2012, an increase of $135 or 18.1%. This increase was primarily attributable to increased advertising and equipment costs. Advertising costs were up $44 per activation reflecting increased brand spending related to the launch of our new Hopper with Sling set-top box in February 2013. Other non-capitalized subscriber acquisition costs increased $25 per activation primarily due to increases in the level of inventory subsidies provided to third party sales channels. Capitalized equipment costs increased $66 per activation, primarily due to three factors. First, the percentage of new subscriber activations with new Hopper receiver systems increased. Second, the Hopper with Sling set-top box cost per unit is currently higher than the original Hopper set-top box. Finally, for new subscriber activations with set-top boxes other than the Hopper set-top boxes, we disproportionately deployed new rather than remanufactured set-top boxes during the first quarter 2013. During the three months ended March 31, 2013 and 2012, the amount of equipment capitalized under our lease program for new Pay-TV subscribers totaled $147 million and $107 million, respectively. This increase in capital expenditures under our lease program for new Pay-TV subscribers resulted primarily from the factors described above. 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 three months ended March 31, 2013 and 2012, these amounts totaled $45 million and $30 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 certain MPEG-2 receivers, as a result of our HD initiatives and current promotions, we currently activate most new customers with higher priced MPEG-4 44 -------------------------------------------------------------------------------- Table of Contents Item 2. MANAGEMENT'S NARRATIVE ANALYSIS OF RESULTS OF OPERATIONS - Continued 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. General and administrative expenses. "General and administrative expenses" totaled $158 million during the three months ended March 31, 2013, a $13 million or 7.5% decrease compared to the same period in 2012. This decrease was primarily related to a reduction in costs to support the DISH pay-TV service. Interest expense, net of amounts capitalized. "Interest expense, net of amounts capitalized" totaled $196 million during the three months ended March 31, 2013, an increase of $61 million or 45.8% compared to the same period in 2012. This change primarily resulted from an increase in interest expense associated with the issuance of debt during 2012. Earnings before interest, taxes, depreciation and amortization. EBITDA was $720 million during the three months ended March 31, 2013, a decrease of $54 million or 7.0% compared to the same period in 2012. The following table reconciles EBITDA to the accompanying financial statements. For the Three Months Ended March 31, 2013 2012 (In thousands) EBITDA $ 719,737 $ 773,970 Interest expense, net (188,558 ) (132,594 ) Income tax (provision) benefit, net (119,452 ) (166,591 ) Depreciation and amortization (205,496 ) (197,295 ) Net income (loss) $ 206,231 $ 277,490 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 $119 million during the three months ended March 31, 2013, a decrease of $47 million compared to the same period in 2012. The decrease in the provision was primarily related to the decrease in "Income (loss) before income taxes." Net income (loss). "Net income (loss)" was $206 million during the three months ended March 31, 2013, a decrease of $71 million compared to $277 million for the same period in 2012. This decrease was primarily attributable to the changes in revenue and expenses discussed above. 45 -------------------------------------------------------------------------------- Table of Contents |