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How Hughes transformed itself from arms maker to satellite broadcasting giant.
Roy Harris, CFO Magazine
March 1, 2000
"Breakout year" is the kind of term executives like to avoid when discussing short-term prospects. The brass at Hughes Electronics Corp., though, isn't shy about it.
"Breakout- -I like that word," says chairman and CEO Michael T. Smith, musing on how some analysts describe the months ahead for the company. Adds senior vice president and CFO Roxanne S. Austin, "I see nothing but tremendous growth in our future." Indeed, the advice she often gives investors is, simply: "Hang on."
At Hughes, breaking out has a double meaning.
In the most immediate sense, the company's white-hot DirecTV business grew from 4.5 million to 8 million subscribers in 1999. This year, with revenues surging past $5 billion, the consumer direct- broadcast satellite (DBS) business will represent three-quarters of Hughes's volume.
But Wall Street also checks daily for signs that General Motors Corp. will spin out Hughes into a separately owned company. Since buying Hughes in 1985, GM has maintained 100 percent voting control over the subsidiary, while also floating shares of GM Class H--one of the first tracking stocks. In February, GM said it would slash its ownership of GMH shares from 68 to 35 percent, but would hold on to Hughes for the foreseeable future. Still, analysts feel it's just a matter of time before a GM spin-out of Hughes.
Beneath the buzz over DirecTV's phenomenal growth and the potential GM spin-out, though, lies a series of dramatic financial moves that put Hughes on the launchpad for both. The actions have enabled Hughes to deliver the "peace dividend" that so many defense contractors promised when the Cold War ended. Until the mid-1990s, Hughes was basically a high-tech arms maker, best known for its missiles, radar systems, and military satellites, along with some auto- electronics and commercial-space operations.
The tale of how Hughes has transformed itself, say Smith and Austin, often gets mangled in the telling--a situation that may be all too familiar to finance departments that fail to get credit when they reshape a business. The standard version is that C. Michael Armstrong, the dynamic executive who spent nearly six years as Hughes's CEO before moving to AT&T Corp. in 1997, single-handedly and even magically turned the weapons producer into a media company.
Closer to the truth, the current Hughes executives maintain, is that the transformation required four years of extremely complex finance work to target manufacturing assets for sale, and to apply some of the $17 billion in proceeds toward expanding Hughes's much smaller, high-growth satellite communications ventures.
Indeed, Smith, a former CFO who was Armstrong's vice chairman, says a team led by then-CFO Charles H. Noski and then- controller Austin basically "dragged Mike Armstrong along to the party," at least when it came to divestitures. "Of course, once we did it, it was his idea," Smith adds with a laugh. (Armstrong declined to comment.)
Austin agrees that the AT&T chairman sometimes gets too much credit for engineering Hughes's space-based future, although she praises Armstrong for building confidence in the nascent commercial satellite operations. "Finance was a major driver in the redirection of Hughes," she says. "I know everybody says they're a strategic business partner these days, but it's really true here."
Austin headed the team that managed the $3.75 billion sale of Hughes's satellite-making operations to Boeing Co. recently, for example. And Hughes benefits, she notes, from the career message that is sent to finance personnel by the rise of Smith and Noski to top operating posts. Within Hughes's 800-person finance stable, the tenure of senior executives averages 14 years.
Last year was a big year for deals, topped by Hughes's acquisitions of DBS companies PrimeStar and U.S. Satellite Broadcasting Co. (USSB), and a landmark $1.5 billion alliance with America Online Inc. (AOL). Important as each was, though, they all sprang from that single blockbuster restructuring that began taking shape in 1995, built around the sale of defense operations to Raytheon Co. That left El Segundo, California- based Hughes a "pure play" in satellite communications.
There are some loose ends to the Raytheon deal, perhaps significant ones. Raytheon, which has stumbled badly since buying the Hughes defense operations, has challenged the $9.8 billion price it paid as more than $1 billion too. But generally, Hughes's escape from its old industry has been spectacularly successful.
"If you look at the totality of it, Hughes really represents a tremendous case of defense conversion," says Cai von Rumohr, an S.G. Cowen Securities Corp. analyst in Boston. "The big deals they made were all the right ones."
And like the top Internet firms, Hughes has satisfied investors that earnings don't count--at least right now--and that cash flow and DirecTV subscriber growth are the metrics to watch. Wall Street's acceptance when Hughes replaced the old earnings-based model, in fact, is one of the finance department's proudest achievements.
"We made a conscious decision to invest in subscriber growth last year," Austin explains. "We've got this competitive window of opportunity against cable, and we need to capitalize on it now." DirecTV's edge: Cable today lacks the digital capability of the Hughes satellite product, and it may be harder, and more expensive, for DirecTV to win subscribers over in the future.
Analysts were impressed last April when Austin began valuing GMH stock on an EBITDA (earnings before interest, taxes, depreciation, and amortization) basis, and were unfazed when Hughes widened its own full- year loss forecast at the same time. The stock price surged, largely because the CFO was convincing in her argument that underwriting the DirecTV subscriber drive was worth the short-term pain of wider losses at Hughes.
"Her message was, 'Hey guys, wake up. This is a cash-flow story,'" says Marc Crossman, who follows satellite stocks for J.P. Morgan Securities Inc., in New York. "I don't think earnings matter any more; right now, we care about building the subscriber base."
It was a good thing analysts were won over. Hughes's 1999 net loss was $291.3 million, compared with a year-earlier net income of $250.7 million. But investors looked at the strong DirecTV sign-ups, and the unit's first quarterly positive EBITDA numbers: $27 million, versus negative $32 million a year earlier. The stock price has climbed steadily since June, when it traded in the mid-50s. GMH shares closed last year above $100, then surged to $127 after the January 13 sale to Boeing.
Advancing From A Retreat
Roxanne Austin's role in the Hughes drama started years before she was named CFO, in 1997. Chairman Armstrong brought her in as controller in 1993, luring her away from Deloitte & Touche, where she was a partner working with Hughes, specializing in mergers. She made the move, she says, in response to "the Mike Armstrong vision, that he was going to change the company and take it to a new level." There wasn't much structure to the plan; indeed, Hughes made niche acquisitions in the defense industry early on. All its businesses--defense, auto electronics, and DirecTV and other satellite-related programs--needed investment. Armstrong's view was that "we're going to grow all of them," Austin says.
At one point, in fact, there had been 263 separate commercial projects vying for dollars. "We took a light- and-stick approach--we'd shine a light on it and hit it with a stick," according to Mike Smith, who turned the CFO post over to controller Chuck Noski in 1992 when Smith became Armstrong's vice chairman. Among those projects, Armstrong was "very heavy on environmental detection," the remote sensing of pollutants, Smith says. "But after a long period of time, we convinced Mike that this was not a long-term business, and we got out of it at the right time."
GM's policy since it acquired Hughes in 1985 had been to keep hands off operations. But after a decade of flat results, the board watched Armstrong's strategy very carefully. It liked the CEO's work promoting new commercial markets and tightening cost controls. When Armstrong, who had been a whiz at IBM Corp., talked of a major defense acquisition, though, Smith says the board "kept hammering away that it looks bad" to be investing in a consolidating industry.
Hughes's four top managers-- all but Armstrong finance-trained-- took that warning with them to Santa Barbara, California, in 1995 for a four-day retreat coordinated by controller Austin. There, operating chiefs presented their business strategies one at a time.
"What we saw was a conflict," she recalls. While its commercial programs clearly cried out for investment, the core defense business needed a multibillion-dollar acquisition, and so did auto electronics. "They were all world-class enterprises, and we were going to have to suboptimize some of them," she says. And particularly for defense, "we came to the realization that we had to be a buyer or a seller to create shareholder value." The decision to sell it became obvious, if not easy. "How many managers of $16 billion companies can say that the best thing you can do, in the strategic interest of each business, is to split up?" she asks.
"Exiting at the Peak"
Hughes management began work on a "triple play," so named because it addressed strategic challenges within the defense, auto-electronics, and satellite-communications lines. Only the satellite businesses would be kept, and Hughes would invest heavily in the most-promising projects, DirecTV foremost among them. GM backed the plan wholeheartedly--as long as Hughes made the sell-offs tax-free, and neutral to the automaker's credit rating.
Mike Smith, who also happens to be GM chairman John F. Smith Jr.'s brother, had already started discussions on his own with Lexington, Massachusetts-based Raytheon as a possible buyer for the Hughes defense business. But the lofty price in cash and Raytheon stock that GM eventually received was pivotal, creating the currency to fund a much larger than expected recapitalization of Hughes.
"We managed to exit the defense businesses at the peak," Smith says. "I don't think anybody has achieved that type of price for those kinds of assets." The two-stage sale, begun in early 1996 but not completed until December 1997, passed Hughes's defense business first to GM stockholders, then to Raytheon. It was the last of the so-called Morris Trust deals before the Clinton Administration eliminated the tax-avoiding merger strategy. (There were alternatives to a Morris Trust sale, Austin says, but none that gave GM the degree of tax- avoidance that it sought.)
The controller's main job was to negotiate what GM would pay for Hughes's Delco auto-electronics business. "We had to divide and conquer at that time; we had a lot going on," she says. "Mike [Smith] and Chuck were working the defense merger." But Austin kept abreast of it all. "Telecom needed a lot of investment, and the defense sale allowed us to put $4 billion of investment into it immediately." Personally, she says of her experience with the triple play, "it was fundamental-- learning to be totally objective and create value for the shareholder."
Through the two years it took to complete the triple play, DirecTV emerged as by far the standout among the Hughes satellite programs. Early on, finance had worked to limit the major exposure DirecTV represented for the company. "The technology side of it was not a concern at all," Austin says. Hughes had mastered the science of working with geosynchronous satellites decades earlier. "The risk was whether people would put an 18-inch satellite dish on their roof and turn off their cable."
They did--in droves. Responding to the marketing drive Armstrong had begun, Americans plunked down $650 or so for dishes and hookups, allowing access to 175 channels (it's now around $200, for 250 channels). By the time DirecTV hit the 3 million subscriber mark in 1996, Hughes was calling it the most successful product rollout in U.S. consumer-electronics history.
A New Set Of Analysts
Once out of the defense business, Hughes had to lobby Wall Street firms to hand over coverage from the aerospace specialist to the satellite- communications expert. "A lot of that was orchestrated at the corporate level by Roxanne," says DirecTV CFO Robert L. Meyers, who has served in numerous finance posts over a 27- year career, and who also talks regularly with analysts. "Clearly, as we evolved the company, we needed to evolve the analysts, because the metrics of the business were changing," he says.
While Hughes's no-profit, high-growth profile may resemble that of an Internet company, Austin says that won't be the case for long. Investors are "seeing the value in their stock price right now, but that stock price will depend in the future on cash flow and profitability." Smith agrees strongly. "If we were like Amazon.com, we'd have a major problem," he says. "It's the typical growth story: We're absorbing a lot of high-end acquisition cost, but eventually we'll cross over." Most analysts see the company returning to the black in 2001.
The PrimeStar and USSB deals last year cheered analysts because they expanded the DirecTV user base, lifting DirecTV's share of the total DBS market to nearly 75 percent. Hughes's AOL alliance, calling for $1.5 billion of AOL investment in Hughes, opens many doors. AOL and DirecTV will market each others' products, and will create new ones with vast potential. DirecTV/AOL TV, for example, could bring a satellite- programming package to AOL's 18 million U.S. subscriber base through a DirecTV set-top receiver. For analyzing the prospects of such relationships, DirecTV CFO Meyers uses his own personal metric: the habits of his 18-year-old son. "I look at the way he goes multiplexing back and forth" on the computer, the TV, and any other information source in the house, Meyers says. "When these kids become the living-room generation, you'll see what the future holds."
As significant as the AOL tie- in was strategically, Austin liked the financing. "We had been considering an equity deal with GM," which agreed to provide $1 billion for Hughes acquisitions, she says. But the AOL arrangements were "much more attractive than selling equity at $50." AOL bought GMH 6.25 percent automatically convertible preference stock for its $1.5 billion, or roughly $70 a share--"benchmark pricing for a deal of this kind," according to Austin.
The finance department was only warming up, though, for this year's $3.75 billion sale to Boeing--a strategic shift for Hughes, which planned during the triple play to hold on to satellite-manufacturing. "At the time, we needed manufacturing to fuel the services businesses," says Austin, and building satellites was a "base of stable revenues and earnings." The growth of DirecTV, and adoption of the EBITDA model, changed everything--and made a sale of the manufacturing business desirable. "The value driver in our company has shifted significantly to DirecTV," she says.
After meeting with Smith and Noski last September to discuss a possible sale, Austin and controller Michael J. Gaines formed a finance team and "put together a very expensive book for Boeing," Austin says. Their 135-page presentation detailed the fit with the Seattle company's own satellite and aircraft businesses, and suggested a beneficial tax structure for the deal. "We had to convince them why they should pay what some might characterize as a premium for the business," she says. Negotiations went smoothly; striking the deal took less than a week.
The next generation of satellites--to be part of Hughes's Spaceway system--now will be produced for it by Boeing. Geared for broadband services, the new satellites will offer high-speed Internet access, corporate services, and interactive capabilities for the AOL-DirecTV tie-in and for other future applications. Hughes retains PanAmSat Corp., a fast-growing, 81 percentowned unit whose 21-satellite fleet delivers global services to a range of customers, including DirecTV.
Of course, the future of Hughes is subject to sudden change in any world where AOL can emerge overnight as the owner of Time Warner Inc. But Hughes boldly aims to become the world's leader in digital entertainment and business communications services--whether delivered via TVs, PCs, mobile phones, autos, or airplanes. Some see Hughes making major acquisitions, perhaps following AOL as the next "surprise" media behemoth.
"Convergence is real, and it's going to keep happening," Austin says. "We clearly will have additional strategic relationships in our future."
Over at AT&T, Mike Armstrong remains a master of the communications universe, having placed his bets lately on cable, with the MediaOne merger. And recently, he cast a much more personal shadow over Hughes, luring Chuck Noski away to become AT&T's CFO--just after the expiration of the two-year "nonpoaching" agreement Armstrong signed when he left Hughes. The departure has elevated Austin's role at the company, and encourages her even more in her ambitions to follow in Smith's and Noski's footsteps, and rise into a major operational post at Hughes. "I think that will occur over time," she says. "Being able to make tactical decisions for an operation is something I have a great desire to do."
For now, though, she has a full plate running finance--and preparing for whatever changes in the GM-Hughes relationship headquarters in Detroit may dictate. Austin doesn't think much would change in finance, even if a spin-out eventually gave Hughes the ability to issue its own shares. The automobile giant has been an accommodating parent, and "nothing has been impeded by our ownership by GM," she says. Still, the CFO concedes, "a megadeal would be difficult in our current structure."
GM sounds happy with Hughes-- for now. "There's no question that having its finance strength at the top levels of the company has been a distinct plus" for Hughes, says GM vice chairman Harry J. Pearce. "Hughes has gone through an enormous amount of restructuring. The spin-off of the defense business, AOL, USSB, PrimeStar--all of those transactions were complex by any measure. And we couldn't have been more pleased about the way they turned out."
As for whether Mike Armstrong got too much credit, the GM executive notes that "he's a charismatic leader, and, quite frankly, the media flocks to a charismatic leader." But he thinks Armstrong would be the first to credit the finance team for its contribution. "Great ideas are cheap," Pearce says. "If they're not executed, they have no value."
INTO THIN AIR
From a young aviation tycoon's private shop to DirecTV, Hughes has flown an interesting path.
1932 Hughes Aircraft Co. formed in Southern California by 27-year-old Howard R. Hughes Jr. as a unit of his late father's Hughes Tool Co.; it builds racing planes.
1937 Radio gear for a round-the-world flight sets the stage for future Hughes avionics businesses.
1941-45 Wartime contracts include gunnery devices, wing panels, and the Spruce Goose flying boat, the largest plane ever built.
1953 Hughes sets up Hughes Aircraft as a separate entity; donates it to nonprofit Howard Hughes Medical Institute, with company income used for medical research.
1976 Howard Hughes dies at 71.
1980 Hughes Aircraft, with 56,000 workers, is California's largest manufacturing employer.
1985 The Medical Institute sells Hughes to GM for $5.2 billion; the company is renamed Hughes Electronics Corp.; the GMH board is created.
1986 Michael Smith is named CFO of Hughes.
1992 Michael Armstrong is named chairman and CEO; Smith, vice chairman; Charles Noski, CFO.
1996 A "triple play" is designed to divest the defense and auto businesses, so the company can concentrate on satellites; DirecTV has 3 million subscribers.
1997 Armstrong goes to AT&T; Smith is named CEO; Roxanne Austin, CFO; sale of defense to Raytheon is completed for $9.8 billion; Hughes buys control of PanAmSat.
1998 Raytheon challenges its price in Delaware state court.
April-May 1999 Hughes builds DirecTV by buying PrimeStar for $1.3 billion and USSB for $1.6 billion; a pact with AOL provides Hughes with $1.5 billion for funding and creates joint products with DirecTV.
December 1999 Vice chairman Noski is hired by Armstrong as AT&T's CFO; DirecTV subscribers reach 8 million.
January 2000 Hughes agrees to sell its satellite- making business to Boeing for $3.75 billion; predicts full-year DirecTV revenues of $5 billion.
February 2000 GM cuts its tracking- stock stake to 35 percent, but says it will hold on to Hughes.
For the Defense
Was Raytheon hurt by Hughes's "staggering errors," or its own poor integration?
If you believe Raytheon Co.'s filing in the Delaware Court of Chancery, Hughes Electronics Corp. built its successful corporate transformation around a billion dollars of accounting misstatements.
Raytheon has sought to reduce the $9.8 billion price for its 1997 purchase of Hughes's defense business, alleging in an October 1998 court filing that a "staggering number of significant errors"-- more than 200 in all--led to the enormous overstatement of the operation's worth.
Details weren't made public at the time by Raytheon, led by then- CEO Dennis Picard. While current Raytheon managers declined to be interviewed about the case against Hughes, CFO Franklyn Caine noted in a statement that Raytheon still believes "the financial statements of the [Hughes] business contained errors," and resolution will probably be "a protracted arbitration process."
But explanations of Raytheon's own recent financial reversal--given to analysts by current CEO Daniel Burnham and Caine--show that Raytheon, too, had some valuation problems under Picard.
Twice since last fall, Raytheon has dropped bombs on Wall Street, first announcing $668 million of charges resulting from an internal review by new management, then in January slashing its already-lowered earnings forecast for 2000 by as much as another $225 million. Failing to deliver promised earnings "fills me with embarrassment, anger, and some guilt," Burnham told analysts, blaming the problem largely on an inability to integrate various acquired businesses. At no point did Burnham mention disputes with Hughes over the price of the defense properties.
"We tried to do too much, too fast, given the size of the task, our state of readiness, and the depth and maturity of our management team," he said, noting that Raytheon ballooned from a $13 billion to a $20 billion company very quickly. "People were so busy working on the nuts- and-bolts details of the integration, they failed to look back and see how the world was changing around us." (A Raytheon spokesman says Burnham doesn't believe those troubles reflect on "one administration or another.")
Hughes CEO Michael Smith won't say much about Raytheon's court claim, but maintains that the problems Raytheon cites in the Hughes-supplied financial data "are not errors." In a Hughes court filing, controller Michael Gaines ticked off 11 disputed areas of objections by Raytheon, including contract losses that weren't fully reflected, underaccrued liabilities, and inappropriate accounting. Gaines said that Hughes followed accepted accounting guidelines in all cases.
Some observers suggest Raytheon may itself be to blame for the rich price it paid. Raytheon earlier broke off discussions to acquire the Hughes defense property in a negotiated deal--at a price below $8 billion, according to knowledgeable sources. Hughes then put the business up for bids.
When the auction began, Raytheon had to compete with Los Angelesbased Northrop Grumman Corp., setting off a war that kicked the eventual price up by nearly $2 billion. Timing helped Hughes greatly; defense-industry consolidation reached a fever pitch in 1997, and Raytheon feared for its competitive position if the nation's premier defense-electronics and missile shop ended up in rival hands. "Hughes was the prettiest girl at the dance, but also the last one," says Hughes CFO Roxanne Austin.