Hughes Hasn't Been This Sexy Since... Thanks to DirecTV, its satellite broadcast service, Hughes Electronics morphed from a defense giant into a white-hot media property. Will Rupert Murdoch get his wish to buy it?
By Christine Y. Chen Reporter Associate Jessica Sung

(FORTUNE Magazine) – Howard Hughes may have been a little mad by the end of his life, but he certainly knew what made the public's juices flow. It wasn't money, though he amassed plenty of that in his varied pursuits, ranging from jetfighter design to commercial aviation to short-range-missile production. It was Hollywood entertainment--which is to say, sex--that brought him notoriety, even if it remained but a glamorous footnote to his career. Today most people associate Hughes Electronics Corp., the last company bearing his name, with aerospace and defense--not exactly sexy.

But now, once again, show biz is front and center. Hughes no longer produces air-to-air missiles or communications satellites. Instead, like its founder's early foray into Tinseltown, its primary business is hawking entertainment to average Joes around the country. After a prolonged metamorphosis, Hughes makes nearly all of its money from its ownership of satellite TV operator DirecTV, one of the most coveted pieces of property in the media world.

As a nod to the Hughes legacy, DirecTV headquarters sits almost on top of the runways of Los Angeles International Airport, snuggled between the drab warehouselike buildings of Raytheon and Boeing. DirecTV's offices, as well as the employees inside them, look like they belong in Indianapolis, not Hollywood, which is 15 miles to the north. Also inside the walls is a command center that controls more than 225 channels of TV programs, news, sports, movies, and pay-per-view beamed from a constellation of five satellites to 9.5 million customers across the U.S. That makes DirecTV the nation's third-largest subscription TV service, with more customers than any operator except cable giants AT&T and AOL Time Warner (FORTUNE's parent). DirecTV not only gives subscribers more choices than analog cable systems (which typically offer 90 channels at most), it also offers a clearer picture and sharper sound. The service has been digital since its launch in 1994; cable companies didn't offer digital services until late 1999. DirecTV is relatively cheap too. Its most popular subscription package costs $32 per month, about the same as a basic analog cable lineup (there's a nominal fee for a dish). Not bad for a venture that ten years ago was merely a pet project on the drawing board of a Hughes engineer.

The interesting problem now is that because of this elegant and successful service, Hughes (with sales of $7.3 billion last year) has outshone its corporate parent, General Motors (with sales of $183.3 billion). DirecTV is responsible for more than 80% of the $35 billion market cap of GMH, the Hughes tracking stock. Compare that to the $31 billion market cap of GM itself, which isn't exactly partying it up these days. Bizarre as it sounds, in the eyes of Wall Street the 92-year-old automaker is worth less than a six-year-old subscription TV service. Not much room for synergy there. So GM decided that it would unlock DirecTV's value by unloading Hughes. Last year GM CEO Rick Wagoner let it be known that Hughes was on the block.

But the knot that binds GM to Hughes is incredibly complex. GM can't simply sell the stock and assets of Hughes, because of tax consequences; and given the turmoil in the stock market, prospective buyers may have a hard time raising the cash that sources say GM is asking--some $40 billion to $50 billion, or about $31 to $38 per share of the Hughes tracking stock. With tech-sector woes dragging down GMH from a high of $47 last March to $27 now, that price is pretty stiff. Nevertheless, intense negotiations have been under way since last summer.

If GM succeeds, it will be the engineer of the biggest media deal of the year. Now that the AOL Time Warner merger is complete, rival media empire builders are looking for the elusive combination of assets that will let them produce all sorts of original content and distribute it to households around the world, by either video, the Internet, or a killer blend of both. Whoever gets Hughes will be able to beam content throughout North America at a stroke, and the list of suitors circling Hughes is a Who's Who of heavy hitters in media and high tech, all with egos as big as Howard Hughes' own. Guys like Rupert Murdoch, John Malone, Michael Eisner, and Sumner Redstone are salivating at the prospect of using DirecTV to distribute their movies and TV shows. Guys like Steve Case and Bill Gates want a piece of DirecTV to bring their corner of the Internet to television viewers.

An asking price of $45 billion or so is a pretty penny for a company that had its origins in the oil fields of Texas. It all began in 1923, when Howard R. Hughes Jr. inherited Hughes Tool Co. of Houston from his father, who had made a fortune developing patented drill bits for the oil industry. Armed with more money than he knew what to do with, and sick of the relatives hovering over him after his parents' deaths, young Hughes fled to Hollywood and immersed himself in the burgeoning film industry. By the 1930s, despite his lack of experience, he had managed to produce critically acclaimed movies like Hell's Angels and Scarface. In 1943 he even jumped into the director's chair, discovering the buxom actress Jane Russell for his controversial film The Outlaw. (Hughes also proved a savvy marketer. For the film's rerelease in 1946, he sent up a skywriting plane to spell out the name of the flick, followed by two circles, each with a dot in the center.)

Hughes' personal life was just as colorful. Known as the World's Greatest Womanizer, he saw his first marriage, to a Houston socialite, end after four years. His marriage to starlet Jean Peters lasted longer, but throughout his life he maintained warm personal relationships with a parade of glamour queens, including Jean Harlow, Lana Turner, Rita Hayworth, and Ava Gardner. A constant presence in Hollywood gossip pages, Hughes was photographed at all the trendy restaurants and movie premieres, seemingly with a different woman each time.

Hughes' passion for speed extended to the skies as well. One of the best pilots in the world, he became the fastest man ever to fly when he reached 352 mph in his personal H-1 aircraft, called the Silver Bullet, in 1935. During the next few years he repeatedly broke his own speed records.

To support his hobby, he launched Hughes Aircraft Co. as a division of Hughes Tool in 1932. The company took off quickly. Howard Hughes also took control of TWA in 1939, and during World War II he branched out into commercial aircraft. He had some flops, most notably the Spruce Goose, a wooden troop-transport seaplane whose only flight lasted less than a minute. But during the Cold War, Hughes Aircraft emerged as a major military and aviation supplier. The company hired the best brains and developed sophisticated equipment ranging from tactical missiles to the world's first geostationary satellites. When Howard Hughes died in 1976, he left a defense powerhouse that continued to grow.

GM stepped in nine years later. Hoping to apply Hughes Aircraft's technological know-how to its autos, it bought Hughes for $5.2 billion. Roger Smith, then GM chairman, was so thrilled that he proclaimed, "Getting Hughes was like getting Cal Tech and MIT combined." Hughes scientists continued to work on exotic defense technology throughout the 1980s, including gear for the Star Wars initiative.

No one knew it then, but around that time Hughes got spectacularly lucky. The FCC opened part of the radio spectrum to applicants thinking about using satellites to beam TV programs directly to viewers. Hughes already owned and operated satellites used by cable operators to relay programs to their systems. It applied for and won a slot in the sky in 1984.

Five years later a group of eight employees, led by a jovial, bearded engineer named Eddy Hartenstein, realized that advances in high-powered satellites and digital compression presented a stunning opportunity: Hughes could create an orbiting system to broadcast dozens, if not hundreds, of video channels to pizza-sized dishes atop homes across the U.S. DirecTV was born.

Hartenstein wasn't the only one to recognize the venture's potential. In 1990 Hughes danced its first tango with Rupert Murdoch. The media mogul's News Corp., along with NBC and Cablevision, joined Hughes Communications in a joint venture called Sky Cable, which aimed to provide satellite TV to consumers around the world. But battling egos and the lack of a clear plan doomed the venture. It folded after only 16 months.

Hartenstein and his team continued on their own. DirecTV launched its first satellite in 1993 and was ready to roll the next year. Most early customers lived in rural areas that cable didn't serve. DirecTV was no bargain then: A set-top box, satellite dish, and installation cost $800. But early reports were so positive that people flocked to buy it. On the day DirecTV launched its service--at a joint called Cowboy Maloney's Electric City in Jackson, Miss.--300 people were lined up outside when the doors opened. "It just took off from there," Hartenstein says. By 1998 DirecTV was offering more than 200 channels to 4.5 million customers, 70% of whom lived in areas where cable TV was also available.

Hughes' transformation into a media company was nearly complete. The Cold War over, Hughes sold its defense business to Raytheon and its satellite manufacturing business to Boeing. DirecTV bought two of its three satellite TV competitors and won the right to broadcast local TV stations, putting it on a more equal footing with cable companies. Hartenstein, now No. 2 at Hughes, even turned into a schmoozer. At a recent breakfast at the Four Seasons in New York City, a power haunt of publishing and media types, one diner after another came over and shook his hand, including NFL Commissioner Paul Tagliabue, one of DirecTV's biggest programming partners. As CFO Roxanne Austin, an Arkansas native, is fond of drawling in speeches, "we went from missiles to MTV."

One of the first guys to appreciate the makeover was the CEO of AOL. In the spring of 1999 Hughes CEO Mike Smith received a surprise phone call from Steve Case, whom he had never met. "He asked flat out if I was interested in selling DirecTV," recalls the soft-spoken Smith. "I told him no but decided to meet with him anyway to see if we could work together somehow." Over seafood at a noisy restaurant in McLean, Va., Smith and Case talked about AOL's interests in television. Three months later AOL agreed to invest $1.5 billion in Hughes. The companies will also jointly market AOL TV, which will offer AOL's interactive content, Instant Messenger service, and e-mail to DirecTV satellite customers. The service should be available late this year.

AOL was the largest in a series of deals to give DirecTV customers more than just one-way video service. Last fall DirecTV joined with Wink Communications to offer 30 interactive channels. Viewers with a special set-top box and remote control can call up information like sports scores and weather forecasts. DirecTV also partnered with TiVo to let subscribers pause satellite broadcasts midstream and digitally record up to 35 hours of video. And Hughes is working with Microsoft to develop Ultimate TV, which will let subscribers record programming and surf the Web on their TVs. The service is scheduled to debut this spring.

DirecTV is also getting back to Howard Hughes' film-industry roots. Last summer the company joined with PanAmSat (of which it owns 81%), IBM, Lucent, and Hollywood's Creative Artists Agency in a technology venture called NeTune Communications. One of NeTune's first big projects is providing a communications system for the makers of the Harry Potter movie, now being filmed in London. As director Christopher Columbus finishes shooting scenes, he can digitally transmit daily footage via satellite to the production studio in Hollywood. The images are clear (crucial for fine-tuning special effects), and the feedback instantaneous. CAA President Richard Lovett says Hughes will become a major player in Hollywood again: "They're very much part of the entertainment landscape's future."

Even on its own, DirecTV would be enough to have media magnates slavering. But the other 20% of Hughes broadens its appeal. Hughes Network Systems (HNS), in Germantown, Md., is applying satellite technology to the Internet with a high-speed online service called DirecPC. Users download data from a small satellite dish at a speed comparable to that of a cable modem. DirecPC had trouble winning customers when it was introduced in 1996. At $40 a month plus $650 for gear, the service was pricey, and the satellite connection worked in only one direction; subscribers still had to keep a phone line free to send data to the Internet.

But in December DirecPC began offering two-way satellite service; what's more, the dish it uses can also handle DirecTV. Says Tom Eagan, a UBS Warburg analyst who covers both cable and satellite: "I upgraded Hughes after I tried DirecPC. It was as fast as any DSL line or cable modem I've used." Hughes plans to jump-start DirecPC just as it did DirecTV--by aiming at the customers in areas that can't receive cable modem or DSL service. Though satellite broadband, as it's called, is unlikely to eclipse cable as a provider of video or data services, Michael Goodman, a media and entertainment analyst at the Yankee Group, says, "There's plenty of room in the market for DirecTV and HNS to grow."

Like others in the Internet business, HNS is looking to tap into the demand for superhigh-speed signals. Expected to debut in 2003 is a service called Spaceway, which will use a new technology called spot-beam transmission that will operate at speeds ten times that of a cable modem and let satellite customers exchange files Napster-style. On top of its consumer businesses, HNS has a lucrative sideline letting corporate customers use its satellites to manage a variety of operations. When drivers pay at the gasoline pump with a credit card, for example, a small terminal beams the transaction over HNS's satellite network.

Now that GM has put Hughes on the auction block, who will get it, and when? Hartenstein spent much of December shuttling between Hughes headquarters in L.A. and meetings with investors and potential partners in New York. News Corp., AOL, Microsoft, Viacom, and Comcast have all signed nondisclosure agreements with Hughes. GE, Sony, and Disney have also shown interest. And sources close to the talks say that regional telecom companies like SBC and Qwest also hope to be part of a deal, if not as outright acquirers then as partners. "All this interest...," Hartenstein says with the slightest of smirks. "It's a validation of what we've done."

Ego-boosting though their attention may be, some players wishing to get close to Hughes face hurdles they may not be able to vault. Take AOL. After receiving FTC approval for its merger with Time Warner in mid-December, AOL reportedly entered serious exploratory talks with Hughes. But it's highly unlikely that the government would let a single company control Time Warner's cable customers and DirecTV's satellite customers. "I'm sure AOL would love to have it, but historically the government has been loath to let cable and satellite get married," says UBS Warburg's Eagan. For the same reason Comcast could also face regulatory obstacles.

Media companies without their own infrastructure might encounter other constraints. Viacom covets DirecTV's distribution network to complement CBS and Paramount Television, which produces TV programs like Frasier. But analysts say that Viacom isn't interested in dilutive deals, which a Hughes purchase would be; and CEO Sumner Redstone is still too busy digesting his acquisition of CBS. The same goes for GE, which could be interested in combining NBC with DirecTV; Jack Welch is focused on the $45 billion Honeywell acquisition, and GE is unlikely to dish out another $40 billion for a satellite company.

So most analysts are betting on Murdoch, who has made no secret of his lust for DirecTV. In his mission to build a global satellite television business, he has poured billions into British Sky Broadcasting and StarTV, which broadcasts in Asia. Murdoch also controls much of the satellite TV industry in Latin America and other parts of Europe. The missing puzzle piece is North America, the largest market for satellite TV in the world. DirecTV would be a perfect fit; Murdoch would finally have his own American distribution outlet for the content he produces through News Corp.'s Fox Entertainment Group. News Corp. plans to take its satellite TV assets public in early 2001, in a company called Sky Global. In an ideal world, Sky Global would marry Hughes.

A global satellite empire would be imposing enough, but that is just a part of Murdoch's design. A News Corp.-Hughes deal could well lead to a grand alliance of media, high-tech, and financial titans and the creation of a content and distribution enterprise of unrivaled breadth. News Corp. has been taking a pummeling in the market lately and can't afford GM's asking price. Murdoch is cutting investments in Internet companies to husband his resources, and he is also calling on a few of his friends to invest in Sky Global. John Malone, chairman of Liberty Media, which owns 18% of News Corp., would reportedly throw an additional $500 million or so into Murdoch's company if he knew Sky Global and Hughes would merge. Analysts say that Microsoft Chairman Bill Gates, who hasn't had much luck building up WebTV, is willing to invest $5 billion in Sky Global, also contingent on a merger with DirecTV. In return Gates would be able to place his operating system in the set-top boxes of the 73 million satellite TV households that Murdoch would control in Europe, Asia, Latin America, and, through DirecTV, the U.S. and Canada.

Also rumored to be part of a deal is investor extraordinaire Prince Alwaleed bin Talal of Saudi Arabia. He owns 3% of News Corp. and has invested with Murdoch in the Kirch Group, a German media conglomerate. He met with Murdoch in November to discuss a direct investment in Sky Global. So did media investor and power broker Gordon Crawford of Capital Management & Research.

As appealing as such a combination might be to all the players, pulling it off won't be easy, largely because of the screwy machinations needed to separate Hughes from GM. The automaker could face heavy tax penalties if Hughes were acquired outright; to avoid that, Hughes would have to control 51% of a merged entity. It's hard to imagine Rupert Murdoch happy with less than half of a new venture, so a management deal would have to be concocted to let him control the assets.

Volatility on Wall Street has also made a deal harder to engineer. But the Hughes brain trust is sanguine. "I'm not compelled to do anything," says CEO Smith. "No one wants to do a deal just to do it. When the time is right and it happens, everyone will applaud." And DirecTV founder Eddy Hartenstein is relishing the limelight. "DirecTV will one day become a great example in business school of how to do things right," he says. It's a remark that has more Hollywood than aerospace to it. But then, he's an engineer who managed to make satellites sexy enough for a bunch of rich old men (and some rich young men) to reach for their wallets and drool. Howard Hughes would surely have approved.