DigitalGlobe And GeoEye Paired: Can An Imagery Merger Capture Investor Imagination?

| About: DigitalGlobe, Inc. (DGI)

On July 23,2012, DigitalGlobe (NYSE:DGI) and GeoEye (NASDAQ:GEOY) approved a merger agreement to create a combined company focused on being the global leader in earth imagery and geospatial analysis. On January 9, 2013, DigitalGlobe and GeoEye received antitrust clearance from the U.S. Department of Justice on the merger. The transaction is not complete until regulatory approvals are received from the Federal Communications Commission and the National Oceanic and Atmospheric Administration. The expected closing date is January 30, 2013.

DigitalGlobe provides high-resolution earth imagery. It offers a portfolio of more than two billion squared kilometers of commercial earth imagery. Services include image capture and processing and delivery of basic and advanced elevation data.

GeoEye provides geospatial information and intelligence solutions. It collects, processes and analyzes massive amounts of geospatial data allowing customers to quickly see precise changes on the ground to protect lives, manage risk and optimize resources. Geospatial refers to methods using software and analytical processes on geographic imagery.

The combination of the companies will result in the elimination of GeoEye shares. GeoEye shareholders may elect to receive DigitalGlobe stock, cash or a combination of both for their shares. The combined Board of Directors will be compiled of six directors from DigitalGlobe and four from GeoEye.

The basic workflow to provide imagery to a client is:

  1. Capture the raw image
  2. Process the basic image
  3. Process the image with advanced features
  4. Perform analysis or build maps
  5. Deliver the image

DigitalGlobe currently provides steps 1, 2 and 5 to its clients and is in the early stages of providing steps 3 and 4. GeoEye provides all five steps. Immediately, the synergy of the merger will provide a full and complete suite of workflow steps to all clients. The merged DigitalGlobe's 2020 vision is to "be the indispensable source of information on our changing planet."

Based solely on DigitalGlobe's current capabilities, 2% of the earth's land mass is captured daily. The merger will evolve to utilizing three of the existing five satellites in orbit now. Both companies are mid-project developing next-generation satellites, which will capture higher-resolution, highly-accurate, more-reliable, multi-spectral imagery at a faster rate. GeoEye's satellite is scheduled to launch this year. DigitalGlobe's satellite is scheduled to launch 2014. When the companies merge, one will launch and one will be grounded as a spare until a 2016 to 2018 launch.

Financial synergies resulting from the merger include a reduction of $1.5 billion in operational expense and capital investment. While revenue is individually projected for 2013 at $309 million for GeoEye and $450 million for DigitalGlobe, 2013 revenue guidance for the merged company is $610 million. The combined backlog is $3 billion. The merged company plans to complete debt refinancing for $1.2 billion when the transaction closes. Both DigitalGlobe and GeoEye were projecting five-year EPS growth of at least 8% per annum.

Currently, both companies individually rely on the U.S. government for 63%-67% of annual revenue. Projected revenue from the United States government for the merged company is more evenly diversified with the remaining customer base at only 50% of the total. In August, 2010, DigitalGlobe entered into a 10-year service agreement with the National GeoSpatial-Intelligence Agency (NGA) for the EnhancedView program. In October, 2011 GeoEye entered into a 10-year service agreement with the NGA for the EnhancedView program. The EnhancedView program:

  • Provides timely, wide-area high-resolution imagery from commercial satellites
  • Provides access to entire commercial satellite archives
  • Enables easy access for the intelligence community, military, Federal agencies and allies
  • Helps fund future satellite capacity.

The service level agreements (SLA) with both companies for EnhancedView were structured as one-year contracts with nine one-year renewal options. Because of funding problems in 2012, the NGA requested GeoEye modify the one-year option to a quarterly option. On September 13, 2012, the NGA extended the EnhancedView SLA with GeoEye only through November 30, 2012. On October 31, 2012, GeoEye received notice the NGA did not intend to exercise the renewal option through August 2013. Beyond the $36.6 million awarded and funded as of September 30, 2012, GeoEye does not expect further funding from the NGA under the EnhancedView SLA. On the other hand, DigitalGlobe did receive renewal through August 2013 for its EnhancedView SLA. Under the contract terms, DigitalGlobe will receive $250.0 million annually, or $20.8 million per month through August 2014. The terms then increase to $300.0 million annually, or $25.0 million per month, for the remaining six years of the contract. The NGA award to DigitalGlobe also provides for up to $750.0 million for value-added products, infrastructure enhancements and other services. The DigitalGlobe EnhancedView SLA represents $2.5 billion of the $3 billion backlog of the combined company.

Also, as part of the EnhancedView award, GeoEye had a cost-share agreement with the NGA to fund the development and launch of its next-generation satellite. For 2012, the budgeted amount of $337 million expected from the NGA represented approximately 42% of the development and launch expense. However, through the third quarter, only $111.2 million or 14% was received toward such funding. At most, GeoEye will receive only $70 million more for a maximum of 23% of the associated 2012 expense. Contrarily, while the NGA agreement with DigitalGlobe required it to increase capacity through the addition of a new satellite, revenue from the NGA increases only as capacity to the NGA increases and DigitalGlobe's next-generation satellite reaches full operational capacity.

The merged DigitalGlobe is committed to completing both next-generation satellites currently under construction. With completion scheduled for both in the near future, development and launch expenses will not weigh heavily on the books indefinitely. Based on the GeoEye backlog, the merger should eliminate $1.842 billion of EnhancedView costs previously budgeted by the NGA and U.S. government for the next nine years.

With a comprehensive suite of products and services, a synergistic reduction of expenses, near-term anticipated completion of next-generation satellite technology, and sound, high single-digit growth estimates, DigitalGlobal and GeoEye are a harmonious merger pair. Coupled with a conscientious reduction in U.S. government costs, the merged company is already proposing to operate as a responsible fiduciary. As the two have captured and collected the earth's imagery, the time is at hand to see if the unified pair can capture and collect income and investor loyalty. It shouldn't take much imagination.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may recommend DigitalGlobe to the investment club to which I belong at the February meeting.

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