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Intelsat (NYSE:I) went public in April 2013, partially based on the expectation on page 2 of its F-1 IPO fling that after several years of slow growth Intelsat was "well positioned to experience growth in free cash flow in the near future." One of the four factors that would drive this growth was, "Our [Intelsat's] $3.7 billion fleet investment program that began in 2008 was substantially complete by the end of 2012, enhancing our future revenue potential." Since its IPO, management of this heavily-leveraged company has deftly exploited the strong bond markets to lower debt service and further reduce operating expenses. It would appear Intelsat is delivering on its promise to pay down debt and increase the value of its equity. Intelsat's Q4 results, while in line with guidance, put the final nail in the coffin of any hope that its pre-IPO expectations of near-term free cash flow growth will materialize.

Investors have been skeptical of Intelsat - its stock is up only 7.27% from its April 2013 IPO, compared to 34.65% for the NASDAQ and 19.11% for the S&P500. Intelsat's Q4 results not only dashed hope for near-term growth, but they unveiled new concerns about revenue and backlog decline. This makes the company long-term success increasingly dependent on the success of the upcoming Epic satellites to offset the declines and allow them to service their debt over the long run.

Intelsat's revenue was slightly down year over year - $2,604 million vs. $2,610 million for 2012. Granted that US sequestration process has taken its toll, as has pricing pressure in Africa. Guidance for 2014 was even lower - $2,450 to $2,500 million. At the midpoint, that is an additional 5.7% decline in revenue. According to its IPO prospectus, Intelsat typically has 82% of its revenue in backlog at the start of the year, so it only needs to sell 18% to make its year. To have a nearly 6% decline in revenue when 82% of revenue is in backlog suggests a much larger projected decline in sales activity during 2014 - perhaps as much as 30%. Obviously, if sales productivity falls 30%, revenue will eventually fall 30% as the company works through its backlog. Moreover, management made it clear that it lacked growth potential with its current satellite fleet - the same fleet that less than a year ago was touted as an engine of growth! Instead, investors will need to wait until 2016 for the new Epic satellites for any hope of growth. The question is whether the company can wait that long and what happens if the promised growth from Epic does not materialize.

A 30% revenue decline would be problematic for Intelsat given its debt load. At $2,604 million in revenue, Intelsat generated $2,032 million in EBITDA. Assuming a similar 78% EBITDA margin, at the midpoint of revenue guidance, that will be $1,915 in EBITDA in 2014. According to management, the company has approximately $950 million in debt service, $525 million in capex and about $75 to $100 million in other expenses. This leaves approximately $450 million in cash flow for debt service and other expenses for 2013 and $339 for 2014. This is consistent with management guidance that the company intends to pay down about $400 million of its $15.3 billion in debt during 2014, but some of that will come through reductions in its current $250 million cash balance.

Intelsat's cash flow seems comfortable on the surface, but we note that it has 43 satellites. Assuming a 15-year average life, they need to launch approximately three satellites a year to replace each of these revenue-generating assets. This costs far more than $550 million, most likely around $900 million (Note: depreciation was $736 million in 2013, but satellite costs have increased, moreover capex guidance over the next three years is considerably higher, ranging from $575M to $850M per year), putting Intelsat dangerously close to cash flow break-even. Moreover, we understand that Intelsat does not carry in-orbit insurance for its satellites. Industry history suggests geostationary satellites fail at a rate of approximately 1% a year. Intelsat generates, on average, about $60 million in revenue a year from these satellites that require approximately three to four years to build and launch. Thus one or two satellite failures could cause problems for Intelsat's ability to service its debt. Additionally, as the Epic satellites launch, Intelsat will begin recognizing its prepaid deferred revenue, which currently stands at $888 million, but based on management guidance is likely to total between $1.0 and $1.1 billion by the end of 2015. This revenue, which management suggests is amortized over the life of the satellite, or about $70 million per year, will not generate any additional cash, lowering its cash EBITDA by that amount absent an increase in revenue. Moreover, those customers who prepaid year in advance, likely received large volumes of capacity at deep discounts. This could "flood the market" to an extent and make it difficult for Intelsat to sell at full price. As a result of these risks, Intelsat is heavily dependent on its bet that the Epic system will allow them to lower their long-term capex and increase their revenue.

Intelsat's problems are compounded by declining backlog. Year-end backlog is down from $10.7 billion at the end of 2012 to $10.1 billion at the end of 2013. Backlog has been trending down quarter over quarter during the past four quarters. The curious issue is that the company was able to come very close to 2012 revenue despite the backlog decline. This suggests the company was able to get to its 2013 revenue via sales contracts of shorter duration. In fact, the decline in backlog suggest the total value of sales made in 2013 was $600 million lower than their 2013 revenue, a decline of about 25%. However, management was clear that it was the short-term government business that took the greatest hit in 2013. So why did backlog decline? We can only surmise that the company signed a disproportionate amount of shorter-term network services business as opposed to longer-term media contracts with large media organizations. Network business is generally less attractive due to both its shorter duration and the fact that network service customers are typically smaller and are higher credit risks. This may also explain the spike in bad credit, from $8 million to $30 million. The additional problem with declining backlog is that it lowers the revenue visibility of the company. It's this visibility, along with strong credit markets, that have allowed Intelsat to borrow at attractive rates. A continued backing decline threatens its ability to borrow at low rates as debt becomes due over the next several years.

Competition is increasing. O3B recently launched service, and other high throughput satellite ("HTS") will be following closely in 2014 and 2015. These HTS satellites have several times the capacity of current satellite. They will likely drive pricing down for point-to-point network applications that constitute approximately 60% of Intelsat's revenue. But Intelsat will likely benefit from increased revenue on its next generation Epic satellites that should offset this loss and may even increase Intelsat's revenue. However, new entrants, including ABS and NewSat are also launching HTS satellites. They are new operators, and unlike Intelsat, can reduce pricing without risking revenue on their legacy lower through-put satellites. At the same time, the march of fiber deployment is continuing in Africa. Demand and margin erosion is likely to continue and even accelerate. The net impact of the above issues is that changes in market dynamics have largely offset Intelsat's progress on cost-cutting and debt refinancing. It's still not out of the woods yet.

Source: Intelsat's Year-End Results Highlight Dependence On Next Generation Epic Satellites