by Armand Musey

Shortly after the beginning of the year, we raised our industry rating on the satellite industry to marketweight from underweight. We believe 2002 was a particularly tough year for the satellite industry, and as a result, most of the satellite stocks underperformed, an admittedly weak market. Even after a strong rally in the fourth quarter, the satellite stocks we cover were down an average of 43 percent in 2002, versus 32 percent for the Nasdaq. As the economy improves, we believe returns will be better in 2003 and are forecasting an average appreciation of 15 percent in 2003. We would point to improving fundamentals as the key catalyst for the group, supported by stronger balance sheets, the potential recapitalization of several of the weaker companies and the swift resolution of the Echostar/Hughes merger.

As we enter 2003, underlying supply/ demand dynamics for the industry, which have been weak for more than a year now, are beginning to recover. This is important because improving fundamentals reduces the risk of these companies failing to meet earnings projections, which in turn should justify the expansion of their trading multiples and support higher share prices. We would like to highlight the following trends as emblematic of improving fundamentals for the group.

DBS Is Taking Share From Cable–We expect DBS growth will continue to be strong over the next two or three quarters, driven by the continued roll-out of local channels, improved DSL availability and aggressive pricing strategies. Strong growth will postpone investor concerns about deteriorating DBS subscriber economics, limiting the potential near-term downside to the stocks. We also believe the potential for a strategic transaction and installation of new management at Hughes that could raise margins, offering a potential upside for shares of GMH.

Satellite Radio Gets A Redo–The satellite radio companies, XM Satellite Radio and Sirius Radio, are in the final stages of fixing their financing issues and should emerge in stronger competitive positions given their reduced financial cost structures. We believe negative investor sentiments regarding initial demand for satellite radio are overstated and attribute lower-than-expected initial subscriber growth to Sirius’s weak roll-out. We think GM is firmly behind its roll-out of XM Radio, and Honda’s investment bolsters its OEM support still further.

FSS Overcapacity Overblown–The Fixed Satellite Services (FSS) industry has scaled back investments in new capacity, which, along with a couple of recent launch failures and the early deterioration of many satellites, appears to be reversing overcapacity faster than originally foreseen. We expect industry overcapacity to turn in late 2003, versus a consensus view of 2004. The industry is also moving forward with consolidation, and we suspect Hughes could accelerate this by divesting Panamsat.

Equipment Demand Improving–Demand for new satellites and satellite equipment has fallen off significantly over the past year. However, a pickup in military spending on space technology and satcom equipment is helping some companies such as Orbital Sciences and Viasat overcome weak commercial demand. We also expect to see the broadband satellite service providers and their equipment suppliers begin to benefit from the resolution of the DBS merger.

Against a backdrop of improving fundamentals, we believe the group is also in better financial health than it was in early 2002, having made substantial progress with balance sheet issues over the past year. While overall net debt has not fallen significantly, many companies have refinanced, lowering their interest expense and consolidating their balance sheets. As most financial restructurings are to be accompanied by operational restructurings, the outlook for several of the weaker companies should improve.

Finally, we view the swift resolution of the Echostar/Hughes merger as a positive catalyst for the industry. It improved the outlook for the DBS stocks if only because it brought a clean ending, while most investors feared prolonged litigation within the termination agreement. Moreover, because both companies are such a large part of the U.S. satellite industry, resolution of the year-long negotiations removes a great deal of downstream uncertainty for other companies in the group. In particular, we look for the broadband satellite service providers and their equipment suppliers to benefit from less uncertainty. We also believe Hughes will be more open to strategic alternatives for Panamsat, which could spur consolidation in the FSS industry. v

Armand Musey is a satellite communications analyst at Salomon Smith Barney ("SSB"). Part of the information provided herein includes excerpts, abstracts, and other summary material derived from research reports or notes published by Armand Musey as a member of the Firm’s Global Equity Research Department. For a copy of the full research reports or notes or to view the research-report disclosure required by the NYSE and NASD rules relating to analyst independence and conflicts of interests, please visit http://www.ssbaccess.com or contact a SSB Financial Consultant. Valuation methodologies and associated risks pertaining to price targets, as well as other important disclosures, are contained in research reports and notes published on or after July 8, 2002. Salomon Smith Barney has received compensation for investment banking services provided within the last 12 months from Hughes Electronics.