The Risk Is Back in GeoEye

| About: GeoEye, Inc. (GEOY)

GeoEye LogoGeoEye, Inc. (NASDAQ: GEOY), a provider of space-based and aerial imagery and geospatial information, hit us with some good news, and a whole host of bad news today.

With GeoEye’s only U.S. competitor DigitalGlobe (NYSE: DGI) going public later this week, lots of attention is being bestowed upon both companies as a true apples-to-apples comparison can now be made as it relates to their satellite fleets, valuations and prospects going forward.

The problem?

As those that follow me on Twitter know, Wednesday GeoEye hosted its fiscal 1st quarter earnings conference call, and there was a little nugget of information about halfway into the call that caught Wall Street and me by unexpected surprise: The company’s newest satellite, GeoEye-1 is experiencing some technical problems which GeoEye is currently evaluating to determine how they will affect the company’s prospects going forward.

As you can see by the stock price, investors sure didn’t wait around for a nice and tidy explanation, and now with more focus on this sector as a result of Jim Cramer highlighting DigitalGlobe on Mad Money, as well as increased attention by various news outlets, now is certainly not the time for GeoEye to be experiencing some technical difficulties.

What follows is a summary of GeoEye’s earnings announcement and conference call, and what you need to know if you own, or are thinking of owning the stock.

New to the GeoEye story?

GeoEye provides space-based, and aerial imagery and geospatial information through high-resolution and low-resolution imagery, imagery-derived products, and image processing services to customers worldwide.

This capability benefits a broad array of industries including national defense and intelligence, online mapping, state and local governments, environmental monitoring and land use management, oil and gas, utilities, disaster management, insurance and others.

GeoEye operates in what in essence is a duopoly with only one other U.S. competitor, DigitalGlobe (NYSE: DGI), and just recently launched and certified their latest satellite, GeoEye-1, which is the most accurate and detailed commercial imagery satellite available today.

I’ll break down this report into 4 parts:

  • Hit Me With The Numbers: Sales, Earnings Beat Expectations
  • Other Business Highlights: GeoEye-1 Satellite Experiencing Problems
  • Conference Call Highlights: Management Discusses GeoEye-1 Issues
  • Bottom Line: GeoEye Presents Much More Risk Now

Hit Me With Some Numbers

Sales up nicely, even without full benefit of NGA contract

Here are some of GeoEye’s earnings highlights (growth from previous year’s Q1/analyst’s estimates where applicable):

  • Q1/2009 sales of $45.2 million (up 25.9%, from $35.9 million in the prior year/vs. $41.9 million projected by analysts)
  • Q1/2009 operating income of $1.7 million (down 69.8%, from $5.6 million in the prior year)
  • Q1/2009 net loss of (-$1.7) million, or (-$0.09) per diluted share (down from (-$.82) million, or (-$.05) per diluted share in prior year/vs. (-$.25) per share projected by analysts)
  • Q1/2009 Gross margin of 45.1% (down from 47.9% from prior year, but up from 43.5% in Q2/2008, down from 49.9% in Q3/2008, and down from 46.7% in Q4/08)
  • Q1/2009 Operating margin of 3.8% (down from 15.7% from prior year, 15.4% in Q2/2008, 23.1% in Q3/2008, and 9.0% from Q4/09)
  • Q1/2009 Net margin of -3.8% (down from -2.3% from prior year, 7.0% in Q2/2008, and 16.8% in Q3/2008, up from -8.9% in Q4/09)

My Take: The numbers came in much higher than expected and should continue this trajectory well into the future, provided there are no major problems with GeoEye-1 (see more below).

The increase in revenue was primarily attributed to the GeoEye-1 satellite beginning commercial operations in February 2009 resulting in increased imagery orders from the National Geospatial-Intelligence Agency (NGA) for their Service Level Agreement (NYSE:SLA) that they have in place with GeoEye.

The reduction in the operating and net margins is mostly as a result of increased depreciation and amortization expenses associated with the costs of GeoEye-1 that are now being deferred and expensed over the life of the satellite, which will be for about 9 years.

What is important about these figures, and more so with the bottom line net profit and EPS numbers, is that as a result of these deferred expenses and amortization costs, GeoEye’s earnings will look artificially low in the next few years and over the life of the satellite so anyone valuing the company based purely on just EPS valuation has to be careful.

For a proper valuation of GeoEye, you need to use the EV/EBITDA figure instead as it excludes these values, which are added back on the cash flow line for operating and free cash flow measurements.

In the end, those are the only metrics that matter, and although GeoEye has a history of high capital expenditures, and will most likely continue to have them for the foreseeable future, especially as GeoEye looks to build GeoEye-2 for launch in 2012, the cash flow figures should show a marked improvement and ramp up quickly as revenue starts dropping directly to the bottom line, and cash flow margins should be higher than net margins going forward.

Other Business Highlights

GeoEye-1 experiencing problems

  • GeoEye’s latest satellite, GeoEye-1 is experiencing some technical difficulties. These could be small or large in nature, I discuss this in more detail in the conference call section below.
  • GeoEye is currently in negotiations with the National Geospatial-Intelligence Agency (NGA) regarding the establishment of a Service Level Agreement (SLA) extension through June of 2010. The current SLA was set to expire at the end of 2009.
  • GeoEye’s cash and short-term investments balance was $ 93.1 million at the end of March 2009, vs. $110.5 million at December 31, 2008, as compared to $234.3 million at December 31, 2007. The decrease from the 2007 cash balance primarily reflects payments made to complete the GeoEye-1 program and income taxes paid related to the GeoEye-1 cost-share payments, and GeoEye-2 payments for initial construction of the camera and mirror.
  • GeoEye is currently evaluating options for financing GeoEye-2
  • GeoEye will be greatly expanding their staff by approximately 120 or more

My Take: I’ll be expanding on many of these points in the conference call section below, but needless to say, aside from the surprising news that GeoEye-1 is experiencing some technical difficulties, the rest of the earnings release was great.

On the last conference call, when the CEO spoke about the SLA with the NGA being extended the stock raced upward during the call, this time around the exact opposite happened as management dropped a potential bombshell on investors informing us of a problem with one of GeoEye-1’s profiles that it uses to take pictures that is affecting the quality of some of the images.

I’m going to go into great detail on this in the conference call highlights below.

Conference Call Highlights

Management drops potential bombshell about GeoEye-1 malfunction

The following are the highlights from GeoEye’s analyst conference call:

  • GeoEye-1 Problem: COO Bill Schuster, when reading from a prepared statement, stated that last week the company found a potential problem with GeoEye-1’s imagery collections.

He further explained that the satellite has several different imagery collection profiles, and that the problem seems to be present with only one profile and not the others, as determined by the company and the maker of the camera, ITT Corp. (NYSE: ITT).

In this affected profile, part of the image lacks color, but the black and white imagery is unaffected.

The issue doesn’t affect resolution or accuracy.

He further stated that it is too early to tell what is causing this issue, or the specific remedies that may apply.

Further, he stated that there was little or no impact for the company as it pertained to their SLA with the NGA.

They are still looking into whether these issues might affect some of the selected needs of some of their other customers.

The COO also stated that they are unsure how this will affect their collections capabilities going forward, if at all, and that they are currently operating the satellite in a way that completely avoids the issue.

On the Q&A portion of the call, an analyst asked if this problem with GeoEye-1 was causing any capacity constraints, and the COO stated that what the company has had to do was eliminate the operating mode that is causing the issue, and that they’ve been unable to automate and optimize those operations, but that they are quickly overcoming those limitations.

He further answered that he didn’t feel that this problem would have any affect on their large area collections capabilities that specifically apply to the SLA with the NGA.

When pressed further and asked if this was a software or hardware issue, or a combination of both, the COO said that they are still trying to determine which it is, however he DOES NOT SUSPECT THAT IT IS A SOFTWARE ISSUE.

My Take: Let’s start here before delving into anything else on the conference call.

As we saw Wednesday, the market didn’t stick around to find out what the true extent of this “problem” might be, and it definitely makes me nervous as well.

One of the primary risk factors for owning shares of GeoEye or any other satellite company (DigitalGlobe owners beware), is that their only source of revenue is hurtling through space at incredible speeds, with little ability to recalibrate or fix problems should they arise.

We already saw that when GeoEye-1 was launched and initially calibrated, this process also ran into problems, and delayed the final check out of GeoEye-1 by months.

The fact that GeoEye is now facing another issue, albeit one that so far isn’t affecting revenues too much at this point, makes me nervous and calls into question the investing thesis in GeoEye depending on the extent of the problem.

For instance, if this problem continues to be minor in nature, and is readily fixable, then we can use the weakness in the stock price to increase our position.

If however, this problem is an extension of, or an outcropping of earlier problems, then we could be looking at additional downside, and possibly an entire loss in certain aspects of GeoEye-1’s capabilities.

What scared me the most though was that the COO stated clearly that he didn’t think it was a software issue!

If it was, that would be good news in that the software issues could be addressed over time, and probably corrected.

I’m not a satellite expert, but I would think that any issue having to do with hardware would be next to impossible to fix unless they are directly tied to software that can be manipulated to correct the hardware issue.

I don’t want to jump to conclusions at this point, but we need to hear more out of the company on this issue to the extent of how much it will affect GeoEye, what can be done to rectify the situation, and what long term affects this will have on future contracts and orders.

From what I understood on the call, and follow up questions on the subject, it feels to me that the issue is most likely a long term one, and one that will affect imagery collection going forward for certain customers and certain of their needs, but not affect GeoEye’s SLA contract, or the majority of their contracts since the problem was only recently detected for what seems to be very niche imagery needs by only a few customers.

I’ll be watching this very closely.

  • CEO Discusses SLA With NGA: CEO Matt O’Connell spoke about how GeoEye didn’t ramp up their full capacity for their Service Level Agreement with the National Geospatial-Intelligence Agency for $12.5 million per month, until April, so Q1’s results contain very little actual revenue dedicated to this agreement.

He further went on to say that if GeoEye does not deliver the agreed upon amount of imagery, the NGA can impose a penalty of up to 10%, but that as of April, they not only fulfilled this capacity, but did so well within the time frame specified for the month of April.

Concerning the SLA, he further went on to say that the current agreement with the NGA expires at the end of November, but that the NGA is looking to extend that agreement through June of 2010 or longer.

The terms of next year’s extension haven’t been finalized yet.

My Take: It was further clarified on the call, that the “penalty” really isn’t a penalty at all, but rather, a delay and deferment of revenues.

So for example, if GeoEye doesn’t supply the NGA with the agreed upon imagery for a certain time frame, then that portion of revenue gets pushed back to the end of the contract and tacked on at the end, up to 10%.

So far, that hasn’t been a problem though as GeoEye seems to be up to date with their imagery collection demand for the NGA even with the problems encountered by GeoEye-1.

In addition, the extension of this agreement for another year is great news for GeoEye’s revenue and predictability.

  • U.S Government Expansion of Commercial Satellite Imagery Purchases/GeoEye-2: The CEO then touched on the recent news that the U.S. government recently decided and issued a press release stating that they were going to rely on commercial imagery providers more in the coming years.

He went on to say that GeoEye is positive on the announcement, and looks forward to hearing more specifics of the plan.

He further stated that they believed that this increase in use of commercial providers like GeoEye and DigitalGlobe, while far away in the past, appears to be much closer to fruition now.

Management also stated the fact that they believe that even with the capacity of GeoEye and DigitalGlobe, there is currently not enough capacity to satisfy the government, and thus the reason that GeoEye has continued to invest in construction and efforts to further their GeoEye-2 satellite program.

To that end, they are focusing their efforts towards having GeoEye-2 ready for launch in the 2012 time frame when they expect demand to really pick up.

He also stated that GeoEye has already invested about $43 million over the last year or so in the camera and other items associated with GeoEye-2, which will have the capacity, should the government allow it, to capture imagery at a resolution of ¼ meter, or about 10 inches, which would put this satellite head and shoulders above any other commercial satellite available today.

Finally, as far as capital expenditures for GeoEye-2, management talked about first feeling out demand, and then making sure that they have an “anchor” customer and/or support from the U.S. government before they devote any further resources to the GeoEye-2 project.

My Take: Management stated that GeoEye has enough capital on hand to make it through this quarter without tapping into the equity markets, and that by the 3rd quarter of the year, they will know more in terms of how they will continue to finance GeoEye-2’s construction and build out, which might involve some combination of debt and equity.

Like I’ve said before, there will come a time when the company will take on either more debt, or dilute shareholders in order to fund their next satellite launch.

  • GeoEye’s International Business: While discussing GeoEye’s international business, the CEO noted that while the NGA is GeoEye’s single largest customer, international business continues to account for nearly half their revenue.

He further stated that GeoEye had recently met with several of their overseas customers and were told how impressed and happy they were with GeoEye-1’s imagery. (This was probably before GeoEye-1’s problems!)

GeoEye will look to expand their international presence throughout the year by brokering more deals, and passing muster with several international regulations so that by the 3rd quarter of 2009, they expect to build this market out further and reap even more revenue.

Finally, the CEO touched again as he did in GeoEye’s last conference call, about GeoEye’s new imagery business model that allows them more income, freedom, and rights to the imagery they collect, all which will lead to a much smoother revenue stream and margin picture.

You can read more about GeoEye’s agreement with international partner Telespazio here.

You can read more about GeoEye’s recently announced deals with 3 other partners here.

My Take: This is just reiterating what we have already known.

In essence, GeoEye-1 is a huge leap forward for GeoEye not just in capabilities, but more so in its ability to generate revenue, earnings, and higher margins for the company on more favorable terms.

The company has way more leverage now than they ever did with IKONOS which they inherited from Space Imaging, and have the capability to not waste the coverage of GeoEye-1 on simple tasks when they can instead have the satellite multi-tasking so to speak, over a given coverage area.

  • Products and Services Business: The CEO touched on the value added work that GeoEye does with the imagery that they receive, which by the way, is done on imagery from any source, not just GeoEye’s imagery from their satellites.

Management also noted that they are still increasing capacity at their production facilities, which will in turn increase revenue in the future, and will be hiring about 120 additional employees throughout 2009 for these and other purposes at the company.

These production services differentiate GeoEye from other providers, especially DigitalGlobe, in that they can do complex imagery manipulation that allows customers to see more with the images they have.

  • CEO stated that Google’s (NASDAQ: GOOG) agreement with GeoEye states that Google has to purchase all the imagery that GeoEye-1 takes, regardless of what it is.
  • DigitalGlobe IPO Discussion: The CEO spoke briefly about how DigitalGlobe’s IPO will positively affect the entire sector and industry of geospatial mapping, and specifically, for the market of GeoEye’s stock as it will bring added attention both in the financial world, as well as media coverage.

Bottom Line

The risk is back in GeoEye

Aside from the news that GeoEye-1 is experiencing some technical glitches that are hardware related, the news on this conference call really doesn’t matter too much right now.

The entire premise of owning shares in GeoEye is predicated on the very fact that GeoEye-1 would be a fixture in space for 7-10 years to come, and propel GeoEye’s fortunes with it.

From my understanding on the call, the problem might be long term in nature, but potentially not affect GeoEye monetarily as they are able to still collect imagery using other modes on the satellite that don’t require the faulty mode.

Now it’s time to start thinking about the worst case scenario.

If GeoEye-1 is rendered inoperable (we aren’t close to that yet), our investment thesis is out the window, and you should run as fast as you can to the exits.

The best case scenario then is that GeoEye is able to fix the problem with limited to no downtime for its customers, and we all can go home happy.

The truth, I fear is somewhere in the middle.

If what GeoEye says is true, that this certain mode affects very few customers in very few instances, then it’s quite possible that the satellite can continue to operate at close to 100% efficiency and capacity for its entire lifespan if GeoEye simply doesn’t use this mode.

Think of this as akin to owning a microwave that has a turning glass plate inside to make sure your food cooks evenly.

If that turning device breaks, you can still use the microwave, you just have to stop it, and turn the food yourself at certain intervals.

The microwave will likely still cook food and last for many years regardless of the plate inside turning or not.

The market initially reacted harshly to the news, and with good reason, but the stock rebounded shortly after hitting a low we haven’t seen for quite some time.

Now comes the tricky part: with comparisons being bandied about between GeoEye and DigitalGlobe, the scrutiny and added risk associated with the unknown satellite malfunction and its affect on GeoEye might leave investors to scramble out of one stock and into the other should they want exposure to this sector.

That leaves us in a sort of limbo.

The bottom line:

If you own GeoEye stock, hold for now. I believe we’ll hear more about this within a week or so, and if I am correct about the problem, GeoEye should be able to function even under the worst case scenario of not being able to fix the problem, but having to work around it.

Of course, if the problem extends itself, worsens, or renders GeoEye-1 obsolete or useless, all bets are off, and I advise you to take your money off the table immediately.

If you don’t currently own shares in GeoEye and if you are a daredevil and have been waiting to purchase more shares in the company or start your initial position but the price had risen to far to fast, now’s the time to start a small position, knowing full well that if things go south, you will lose virtually your entire investment as a result of the shuttering of GeoEye-1 if that happens, which is a very small risk at this point, but much higher than it was just yesterday.

Here are my current odds on what might happen:

  • GeoEye-1 regains full functionality: 5-10%
  • GeoEye-1 remains in its current state: 80-90%
  • GeoEye-1 loses all functionality: 5-10%

In the mean time, stay tuned by following me on Twitter for real time updates before I post them on my website as soon as I become aware of them.

New to the GeoEye story?