Iridum's (IRDM) CEO Matt Desch on Q2 2014 Results - Earnings Call Transcript

Aug. 1.14 | About: Iridium Communications (IRDM)

Iridium Communications Inc (NASDAQ:IRDM)

Q2 2014 Results Conference Call

July 31, 2014 – 8:30 AM E.T.

Executives

Steve Kunszabo – Executive Director, IR

Matt Desch – CEO

Tom Fitzpatrick – CFO & CAO

Analysts

Greg Burns – Sidoti and Company

Chris Quilty – Raymond James

James Breen – William Blair

Jim McIlree – Chardan Capital

Andrew Spinela – Wells Fargo Securities

Robert Hoffman – Princeton Opportunity Partners, LP

Operator

Good day, ladies and gentlemen, and welcome to the Iridium second-quarter 2014 earnings conference call. At this time, all participants' lines are in a listen-only mode. Later we will be conducting a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to introduce your host for today's program, Steve Kunszabo, Head of Investor Relations. Sir, you may begin.

Steve Kunszabo

Good morning, and thanks for joining us. I would like to welcome you to our second-quarter 2014 earnings call. Joining me on the call this morning, our CEO, Matt Desch; and our CFO, Tom Fitzpatrick. Today's call will begin with a discussion of our 2014 second-quarter results, followed by Q&A.

Before I turn things over to Matt, I would like to caution all participants that our call this morning may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that are not historical facts, and include statements about our future expectations, plans, and prospects. Such forward-looking statements are based upon our current beliefs and expectations and are subject to risks, which could cause actual results to differ from the forward-looking statements. Such risks are more fully discussed in our filings with the Securities and Exchange Commission.

Our remarks today should be considered in light of such risks. Any forward-looking statements represent our views only as of today. And while we may elect to update forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if our expectations or views change.

During the call, we will also be referring to certain non-GAAP financial measures. These non-GAAP financial measures are not prepared in accordance with Generally Accepted Accounting Principles. Please refer to today's earnings release and the Investor Relations section of our website for a reconciliation of these non-GAAP financial measures to the most directly comparable GAAP measures.

With that, let me turn it over to Matt.

Matt Desch

Thank you, Steve, and good morning, everyone. Jumping right into it, as you can see, we followed up our very good start to the year with another solid quarter of across-the-board growth. Total service revenue again grew 7%, with our commercial M2M business leading the way on a 17% year-over-year gain. We affirmed our 2014 and long-range outlooks for all key metrics today, and I am really excited to be building and testing new satellites as we look ahead to our first planned Iridium NEXT launch, less than a year away.

Before I update you on our progress and some key strategic areas, I wanted to mention our successful credit facility amendment and the related capital raise, which we completed in the second quarter. This was perhaps our most significant financial objective in 2014, ensuring that we once again have a strong funding plan as we embark on the peak spending years to complete the Iridium NEXT program. I am thrilled to have this done, as it allows us to focus completely again on growing our core business and capitalize on our future revenue drivers, such as Aireon and Iridium PRIME.

And I want to thank my team, and particularly my partner here, Tom Fitzpatrick, for their leadership during this process; our credit facility lenders, for their cooperation and guidance in hashing out a revised plan; and our shareholders, for supporting a successful transaction. I think we all share the view that we will be rewarded by the extraordinary change we expect in our future cash flow profile. In case you missed the details when we were on the road in May meeting with many of you, Tom will summarize them in his remarks.

Now we can turn to outlining the development news around our major businesses and programs. As far as our network goes – and I can report again, and there is no surprise here – that it is healthy and continues to deliver strong quality statistics. Our customers enjoyed an excellent experience today when making a call or sending telemetry data from a remote asset, and this will only continue when the new constellation is connecting them from all over the world. And don't just take my word on our network health. Speak to our customers and partners and look at our growth.

As far as Iridium NEXT goes, I know I also emphasize this each quarter, but it grows with importance as time passes, and we close in on our first launch. We are on schedule to have the Iridium NEXT system fully deployed in 2017, and are tracking on budget with the capital program.

We have been highlighting the progress of our Iridium NEXT program, as it seems like we are reporting the new milestones just about every day. For example, we recently announced that the first 5 main mission antennas, or MMAs, were recently completed by our PRIME contractor, Thales Alenia Space, signaling their move into high-volume production for the MMAs on all 81 space vehicles. These very complex and sophisticated antennas are at the heart of each satellite, making the connections to customer devices, and they are one of the most complicated components in our satellites to engineer and build.

Earlier this month, we also conducted our first successful test call using an Iridium phone over Iridium NEXT hardware. This is quite a big milestone for our technical team, as it validates the architecture and technology of the new network, and is the starting point for the extensive testing program to come over the next year.

On the launch services front, SpaceX just finished its dispenser qualification testing for the Iridium NEXT rockets. These rigorous tests on the dispenser, which is the key assembly that holds our new satellites to the rocket during launch and manages their separation at the right time, help ensure that each new satellite will be placed safely into the proper orbit. We continue to be encouraged by SpaceX's progress, and we are pleased to see another successful satellite delivery mission earlier this month. Their launch quality remains excellent, and they're scheduled to really pick up their launch pace as year goes on. We are confident they will be ready to start our primary launch campaign in late 2015.

Finally, we have begun working closely with device and terminal manufacturers to develop higher-speed broadband services that will become available as Iridium NEXT is launched. These products will offer higher data speeds and enhance voice quality, and are a step along the way to the new network's full capabilities. We have just begun the process of selecting the initial Iridium NEXT terminal suppliers in the aviation, land, and maritime markets, which should lead to new products and higher-speed service availability for customers as early as 2016, once the new network is about halfway done. Having our broadband terminals created by external manufacturers, using core technology modules that we produce, is a new approach for us. But we think it will bring more innovation and new distribution channels to support our future growth.

Our Aireon business also continues to hit both key financial and technical milestones. In late June, the joint venture completed all the necessary requirements for its next tranche investment from both NAV Canada and its 3 European partners. With milestones now complete for nearly $200 million of its $270 million total funding commitment from these investors, Aireon continues to have the access to the capital needs to develop the world's first space-based global aircraft surveillance system.

With 5 customer data service contracts in hand, it has become increasingly clear that the Aireon service will become the standard for air traffic control over the North Atlantic corridor, and interest from the rest of the world is increasing as the benefits of this global air traffic management system are recognized.

The Aireon leadership team and our joint venture investors also continue to work closely with the FAA as they evaluate adoption of the system in their own footprint, supporting our expectation that Aireon will meet its hosting fee commitment to Iridium in the second half of 2016 and 2017.

Before I wrap up, let me spend just a few minutes on our progress in the maritime business, as well as the launch of our new global satellite Wi-Fi hotspot, Iridium GO!. Our Iridium GO! product is now commercially available, as we began the first round of shipments to our partners just last week. The early order book has been strong, and we see this latest Iridium innovation strengthening our leadership position in the core handset business.

With one of the smallest form factors in the industry, it allows our customers to connect with their smartphones, tablets, and other personal devices anywhere in the world, providing access through their trusted devices where no other networks exists; or networks do exist, but are too expensive to use. As we have listened to the initial feedback from our partners, many interesting use cases have emerged: from an enterprise customer with loan workers in remote areas that need emergency communications; to the crew aboard a boat that shares this device with each other to check weather, read emails, and send position reports. We think it is going to be a hit in the general aviation market, and are also seeing strong interest from the military customers, who increasingly want to use their smartphones when deployed.

It is also the lowest-cost device and service offering that we have ever made in this category. And while it will naturally attract a whole new class of consumers, it should also have broad appeal amongst our established base of industrial and government users.

Finally, one of the most unique and powerful capabilities of the product is its open interface for app developers to control the Iridium GO! connection directly from their apps, and we have almost 30 developers licensed now to do that. Maritime and aviation weather enterprise order management and other Iridium GO! ready apps will only help promote the device to new markets and customers in the future.

As for the maritime business, we're starting to see the turnaround we expected, as Iridium OpenPort service revenue grew 15% when compared to the prior-year quarter. New customer activation rates remain solid, and we have a nice pipeline as recent fleet wins are still in the installation phase. Customer churn continues to decline as the new improved Iridium Pilot units are performing well in the field. And we continue to work closely with our partners in rebuilding their confidence in the product with expanded shipboard service, targeted retention programs, and attractive pricing. We think this business line will again be a bright spot in our portfolio in the near future.

Importantly, we also took a big step in early July on our path to become certified for Global Maritime Distress and Safety System Services, or GMDSS. Our application of the governing regulatory body was reviewed and overwhelmingly supported by the delegates of various countries for advancement to the next stage. Final approval of our submission is expected by mid-2016. Now, this will be a big win for the maritime industry and its customers who not only need an alternative to the incumbent provider for these safety services, but more specifically need a carrier that has global coverage and can provide this vital link in the expanding shipping and trade routes of the polar regions. We view this as a key initiative that expands our addressable market by offering a single service to satisfy both safety and operational communication for vessels, and ultimately a boost to our long-term service revenue profile.

In closing, we had a strong first half of 2014 in both strategic and operating terms. There has been a flurry of activity with the Iridium NEXT program as we are now within a year of our first planned launch, and Aerion continues to gain momentum as it hits financial and technical milestones. Our funding profile is on firm ground, with a credit facility amendment and capital markets activity behind us. And we are seeing good overall performance in our key business lines. We look ahead with confidence as we embark on the early chapters of this transformational period in Iridium's history, and I look forward to updating you again in October.

So with that, I will turn it over to Tom for a more detailed financial review. Tom?

Tom Fitzpatrick, Iridium Communications Inc. - CFO and Chief Administrative Officer 4

Thanks, Matt and good morning, everyone. I am going to dig right in and summarize our key financial metrics, then outline the 2014 and long-range guidance we affirmed this morning, and finish with a review of our recently amended credit facility and related capital raise.

Iridium reported second-quarter total revenue of $102.5 million, which was up 8% from last year's comparable period. Total revenue benefited from approximately a $4.8 million increase in the high-margin service component. Operational EBITDA came in at $54.7 million, and increased 7% from the prior-year quarter. Our operational EBITDA margin was 53% for the second quarter, down slightly from 54% in the year-ago period.

From an operating viewpoint, we generated commercial service revenue of $60.2 million in the second quarter, yielding 6% growth over last year. We added 29,000 net commercial customers during the quarter, up 12% versus last year, with the gain being pretty being evenly split between our commercial voice and M2M businesses. Commercial M2M data subscribers now represent 46% of billable subscribers, an increase from 42% during the year-ago period. The second quarter's performance in our commercial market was consistent with our outlook, and supportive of the long-term service revenue trajectory we see for this business.

I would ask that you consider the following elements. First, our leadership position in the legacy telephony business remains defensible, and we expect this business will continue to expand in the low-single-digit range as we look out over the next few years. Second, a robust growth rate in the M2M sector that should be bolstered by further penetration of the heavy equipment OEM market. In fact, we signed up a large, multinational manufacturer of agricultural and construction equipment at the tail end of the second quarter, and expect to bring in another heavy equipment OEM before the end of the year.

As we have shared before, we are in various stages of bringing new business on board with brand-name players in the agriculture, construction, energy, and mining sectors. In some cases, we are just beginning to introduce these customers to the value of Iridium. And, in others, we are conducting field trials and finalizing service agreements. These deals serve as evidence of our momentum in this space, and we continue to have a strong pipeline of potential business as we look ahead. And this is on top of the strong growth we continue to see from our traditional customers in key vertical markets.

And, finally, as Matt summarized, we returned to growth in the maritime business as Iridium OpenPort continues to regain its footing; with future opportunities, such as GMDSS certification, only strengthening our competitive position.

Turning now to our government service business, which posted revenue of $16 million, representing 11% year-over-year growth, driven by our fixed-price airtime services contract with the Department of Defense. We continue to work with our counterparts in the government to help them roll out Iridium services on a greater scale as they take advantage of their unprecedented access to our network and services. It is also worth noting that two task orders totaling approximately $14 million were recently executed by this customer. The first task order funds modernization efforts and Iridium NEXT readiness at their dedicated gateway; while the second task order was sponsorship from the Naval Surface Warfare Center supports R&D spending for new products and enhanced services. Both are great examples of our growing partnership with our single-biggest customer.

Focusing next on the equipment line, which recorded revenue of $20.3 million, a 3% year-over-year increase, resulting from higher overall sales volumes. I would add that this quarter's gain did not include any contributions from our new product, Iridium GO!, which began shipping to our partners last week. Taking this into consideration, we continue to expect our equipment revenue in 2014 will be greater than it was in 2013, even assuming that our handset sales will be relatively flat during the year.

Moving now to our 2014 and long-range financial guidance, which we have burned across the board this morning, we continue to expect operational EBITDA between $205 million and $215 million for the full-year 2014, which compares to $201 million in 2013. On the same basis for the full-year 2014, we forecast total service revenue growth of between 2% and 4%.

I would like to emphasize, as I did last quarter, that when comparing our 2014 to our 2013 results, it is important to adjust for the approximately $6 million non-recurring benefit of last year's prepaid airtime policy change. When modeling out the second half 2014, the primary impact will be on our fourth-quarter results, as more than half of this non-recurring benefit was booked in the fourth quarter of 2013.

As for our long-range outlook, we continue to expect a compound annual growth rate for total service revenue between 8% and 12% between 2014 and 2018. We expect an operational EBITDA margin of approximately 60% in 2018. We expect negligible cash taxes from 2014 to approximately 2020. We expect peak net leverage of approximately 6.5 times in 2015, and we expect net leverage of approximately 4 times in 2018.

Before I wrap up on our guidance, I just wanted to spend a minute putting our second-quarter R&D costs into the appropriate context. You will see that our GAAP R&D expense in the second quarter increased by approximately $2.9 million versus last year. This increase relates directly to the Iridium NEXT development expenses associated with enabling faster speeds on our terminal equipment that Matt described. Comparable investments are being made to our satellite and ground infrastructure, and these expenditures are treated as capital. All of these expenditures are included in our approximately $3 billion plan for Iridium NEXT.

We expect that our R&D expense in the third and fourth quarters of 2014 will accelerate from the second-quarter level to approximately $6 million, as these Iridium NEXT investments increase in line with our overall Iridium NEXT capital spend.

We anticipate that R&D expense for 2015 will be down from its 2014 peak.

We also want to note that the change to our non-GAAP reconciliation schedule related to the accounting treatment of our area on investment. Aerion is recorded as an equity method investment in our financial statements as Other Expense. This is a non-cash expense, and represents the customary GAAP accounting treatment for the joint venture. We have broken this out from Iridium NEXT expenses as a separate line item in our press release table for the second quarter. And we will continue to do so going forward, though we expect future amounts to be immaterial to our book investment having been written off as a result of book losses recorded to date under GAAP.

And, finally, a review of our capital structure and liquidity position. As of the end of the second quarter, we had drawn $1.1 billion from the COFACE facility, and had a cash and marketable securities balance of approximately $500.5 million, which includes the proceeds from our recent deal.

Turning now to the details of our credit facility amendment, and related $220 million capital raise. Like Matt, I am happy with our successful execution of this offering. Our new agreed banking case with the credit facility lenders gives us the needed cushion and flexibility to execute our operating plan during the heart of the Iridium NEXT construction launch period, while the capital raised fortified our funding profile and puts us on more solid ground.

Of note, the new terms of the credit facility defer $76 million in debt service reserve account payments until 2017. And this is represented as restricted cash on the balance sheet. The amendment also delays our first principal payment until early 2018. These new provisions substantially improve our cash flow profile during the peak spending years for Iridium NEXT.

In wrapping up my thoughts, we are on the right track, as we reflect on our accomplishments in the first half of 2014. We recently cleared several important hurdles in our Iridium NEXT program. Aerion is moving forward in knocking down its key objectives. And we are benefiting from broad-based financial contributions from our core businesses. The credit facility amendment and capital raise are also done. We are on the cusp of a very exciting time, and I feel like best is still ahead of us.

With that, I will turn things back to the operator for the Q&A portion of this morning's call.

Question-and-Answer Session

Operator

[Operator Instructions] And first question today is going to be from the line of Greg Burns from Sidoti and Company. Your line is open.

Greg Burns – Sidoti and Company

Good morning. Just a question on some of the new machine to machine wins. Can you just expand upon the scope of those wins? Is it going to be across the full product line just like with the Caterpillar, or will it be a subset of the equipment that they are rolling off?

Matt Desch

Yes, there are – it is a pretty sizable pipeline of companies who are looking to move to Iridium, particularly in the heavy equipment OEM space, include the agriculture and some other sectors and, as Tom mentioned, there is a few more. Unfortunately, they don't like to have their names announced. We would love to do that, but a lot of them are sensitive about public announcements. So we will just have to kind of do like we did today and just tell you that we are winning deals and converting that pipeline.

But, yes, in most cases, they are using both the 9602 for, say, position reporting and basic information. And, in some cases – not all cases – but some of them have much higher demand in uses that require faster speeds, circuit-switched data, and so they use the 9523 and would be a little higher ARPU in those cases. But it really varies because each of the companies we have been talking to and working with seem to have a slightly different strategy, geographical footprint, interest in how they use telematics specifically, but certainly supports our whole product line.

Greg Burns – Sidoti and Company

Okay. And in terms of some of the new products, what is the timeline around launching some of the other new products that you have talked about in the past, like commercial push to talk? And with Iridium GO!, what is the positioning of that product? Do you expect that to cannibalize handset sales to some extent going forward?

Matt Desch

Yes. So, as far as commercial push to talk, that is a product for later this year. It is on track for – actually, we're going to be doing demos and beta trials here in not too long. And I think more of that is a fourth-quarter product for 2015 sort of availability. It is going very well and we are really excited about the potential of that.

As far as Iridium GO! goes, it will – we think it is positioned to complement satellite phone service. I think there will be some transition, but we really kind of priced it and positioned it in a way that I think it will draw in new customers, primarily.

I am sure there will be some conversion of some existing customers, but really if you are first responder and – or an occasional user, having to – even as simple as the product is to set up, to hook up to your handset, it is still not really what you want to do in terms of anybody being able to grab the product and using it. So we are seeing – we haven't really seen that big of an effect, really, at this time with our handset business. It just kind of continues on.

But we think we are going to bring in some new and expanded customer base with the expanded functionality and more consumer orientation, if you will, of Iridium GO!. And, as I said, I really think that this interface that we see these app developers, who are going to control it, they are going to be promoting it to sort of new segments that really didn't think of satellite phones before. They really wanted to use their handsets, but were away from cell towers. And they will see Iridium GO! as a much more natural product for them.

Greg Burns – Sidoti and Company

Okay. Thanks. Then just back to the machine to machine wins, how should we think about the revenue contribution from some of these new customers? Is that like a late 2015 kind of event?

Matt Desch

It does take time for when we win these deals for them to start building it into their vehicles and into their product lines. And so, typically, when we win one of these things it takes a good 12 months for it to kind of start converting. That is why winning Caterpillar last year will start converting later this year and into 2015 and most of these will be more 2015 sort of revenue contributions. Is that how you see it, Tom?

Tom Fitzpatrick

Yes, it is.

Greg Burns – Sidoti and Company

All right. Thank you.

Matt Desch

Thanks, Greg.

Operator

Thank you. Our next question comes from the line of Chris Quilty from Raymond James. Your line is open.

Chris Quilty – Raymond James & Associates

Thanks. Wanted to follow up on a comment I think that Tom made that you expect handset sales to be flat for the year. If I look at Q2, however, I think at least voice and data, which does include OpenPort to kind of 14,000 a quarter, and in all of last year, you only added about 8000. So I am seeing it hard where you are not going to be up, especially with Iridium GO! adding to that. Did I hear that statement wrong?

Tom Fitzpatrick

The statement was relative to equipment sales, not net subscriber additions. We think about handset sales in 2014 as kind of flat versus 2013. So I think you are just mixing up subscriber additions with handset sales. That is not a one for one match there.

Chris Quilty

Okay. Are there that many handsets out there that are not activated that are just getting turned on?

Matt Desch

I am not sure we really kind of track it that way. I mean, there are sort of 2 separate activities in that – you know, as we fill the channel and that varies dramatically quarter by quarter, that will affect equipment sales. But then we see net activations. And remember, net activations are not just putting those new phones on, but it is also net of devices that get turned off. And so it is kind and apples to oranges in a lot of cases. I mean, they correlate in some ways, but not so directly that I think you could make conclusions out of them necessarily.

The bigger picture here is that our handset business has stayed very stable. It is one of the reasons why we feel very comfortable now after increasing competition over the last 3 or 4 years. We still see a nice solid handset business. And then, as you said, we are adding to that now with Iridium GO! in the second half.

And next year we are adding to it with commercial push to talk, here coming later this year, which will – which I think kind of draw in this sector as well. And all that is a positive. But, again, we still see this as a solid not as fast growing business as our broadband or M2M businesses or other areas that are growing.

Chris Quilty – Raymond James & Associates

Okay. And some of your partners have talked about some pretty sizable preorders for the Iridium GO!. Just to clarify, you won't recognize those until they are shipped and a customer actually turns it on, right?

Matt Desch

Well, we recognize revenue for equipment as we ship the product. And so that will start happening in the third quarter for Iridium GO!. We recognize service revenue as it is used, in the case of – or bought, really, by the customer. So that won't start either until really the third quarter.

Chris Quilty – Raymond James & Associates

Okay. Also, on the netted Iridium or I guess the military version the DTCS, can you give us an update on where that system is in terms of deploying?

Matt Desch

Yes. As we said before, just sort of an overall view there, the government spent a lot of money over the previous years and deployed a capability that was sort of regional in base. They called it phase 2, sort of evolved. Those are still out there and have been deployed, but they stopped funding it because of funding issues over a year ago, and things sort of ground to a halt in terms of growth and new activations just because they really wanted to evolve it into a global service. In fact, that is what they call it now: DTCS Global Service.

Some money is starting to flow again on that, particularly through our partner Exelis, and that also flows into us. And Tom talked about task orders we have received right now to start doing work on that again; still some more work to happen on that.

Frankly, as you can tell, we kind of moved ahead on the commercial side and now are finishing the commercialization of a global service product on the commercial side, which will be now in ahead of that government product. But I am still believing that that global DTCS product will be out in 2015; 2016 we will start seeing more of that.

Chris Quilty – Raymond James & Associates

Okay. And you also mentioned that there is the possibility of selling some Iridium GO! to government customers. Would that fall within the existing service contract or that would be an add-on?

Matt Desch

Well, it would be an add-on in terms of equipment. The base service would be included in there – in the EMSS service contract. So it wouldn't necessarily add to service revenues on that front. But, again, I mean, that is a perfect example of how that EMSS service contract is only bringing, for new subscribers and new applications, into our base.

And it has been nice to see, frankly, now that we are 9 months into that or so, that our subscribers are growing. And the funnel is sort of very active in terms of new activities because they see in these kind of difficult times from budget perspective, that the Iridium network is a very attractive base for them. So it is consistent with that.

Chris Quilty – Raymond James & Associates

A follow up on the OEM; I think you had previously said that Caterpillar hardware would begin shipping in the late part of the first half, implying you would be done shipping already. Has that shifted to the right a little bit? I thought I noted in your comments that you are now saying it is now more of a back end of the year.

Matt Desch

No. We didn't say anything really about Caterpillar from – because that has really stayed on track. We did make some shipments to them at the end of the second quarter, so things are starting to move there. Their validation is underway.

They are still on sort of the same timeline that we have talked about and are excited to see them start to ramp up more later this year and into 2015. But they started to see at least a little bit there in the second quarter.

Chris Quilty – Raymond James & Associates

And with your other OEM customers, are these the types of deployment where you are being designed in, in the factory at the production level, and the OEM customer is paying for the service? Or is it something that is being done as an aftermarket add-on where the end customer has to select it?

Matt Desch

It varies. It isn't completely the same on every OEM customer. It typically is – we are being built in at the factory. That is why it takes some time. There is potential in most cases for sort of an aftermarket add-on to existing services.

But, for the most part, I think the focus is going to be on new products going out the door going forward. And, yes, the service revenue sometimes will be paid for by the end customer or by the end dealer and in some cases will be picked up, if you will, by the factory. But it is just really – varies based upon the telematics strategy of each OEM.

Chris Quilty – Raymond James & Associates

Okay. And on the end-to-end net adds during the quarter, can you give us any sense of the makeup of the customer base there? Has there been any change or shift? Is it now a third of it coming from OEMs or is it still pretty broadly based?

Matt Desch

No. In fact it is actually very little from OEMs. I mean, that really hasn't – like I said, just a little bit has started to flow from Caterpillar. Pardon me?

Tom Fitzpatrick

It is equipment. We are seeing Caterpillar…

Matt Desch

We haven't got any service revenue there at all. That is just equipment flowing. From a service revenue perspective, yes, it is still a very broad-based across the board across all the applications that we have traditionally supported. There has been really growth in most sectors, whether it be in buoys in the ocean. There are some new customers in there, balloons floating around, that sort of thing, that are being tracked.

I think the personal communication space has sort of grown a little bit more this year than last year. You know we have a number of suppliers in that space, including some in almost a consumer sector and we are seeing nice growth there. I think it just takes time for them to build themselves into the retail channel and I think that has started to grow.

But, really, it is a pretty broad-based growth level in many different sectors. I know we focus a lot on heavy equipment OEMs because it is the newest and probably biggest needle mover for 2015, but we are really seeing kind of broad-based success across M2M sectors.

Operator

Thank you. Our next question comes from the line of James Breen from William Blair. Your line is open.

James Breen – William Blair & Company

Thanks for taking my question. Just a couple of questions. One, was there anything particular in the commercial voice side that led to the positive inflection this quarter from a subscriber standpoint?

And then, just looking at the income statement, R&D expense was up quite a bit from the first quarter to the second quarter. EBITDA margin would have been even higher would have had it been sort of at first quarter levels. Just wondering if there is any certain trends there we should be thinking about or for the full year. Thanks.

Tom Fitzpatrick

So Jim, I don't see anything in the commercial voice. The quarter was strong, but if you look year to date, we are kind of up. We were 12,000 net adds for the 6 months versus 11,000 last year. So I wouldn't call it an inflection point in the second quarter, where it is a good quarter. We are happy to have posted it, but I wouldn't read much more into it than that.

And on the R&D, there is really two things. The R&D that affects – that is up that affects EBITDA would be from new products like commercial push to talk. So that is just an investment in our products. The pronounced increase, as I said in my remarks, relates to NEXT spending – as part of our NEXT capital program.

Terminal equipment under GAAP has to be shown as R&D, whereas satellite investments and ground infrastructure is capital. All of it is part of our approximately $3 billion plan for NEXT. It was kind of just geography.

And so, but as we indicated, a significant portion of the increase sequentially and year-over-year relates to this NEXT spending and we see that – those R&D expenses that are NEXT-related to continue. And, in fact, it will accelerate in the third and fourth quarters to approximately $6 million. But, that which affects EBITDA really relates to a commercial push to talk spending that was higher in the quarter than the prior quarter.

James Breen – William Blair & Company

Okay. Thanks. And so as those – as that spending happens associated with NEXT, that will continue to be elevated through the first couple launches in 2015 and then starts to come down

after that?

Tom Fitzpatrick

Yes, we are calling 2014 a peak and that we think 2015 will be down sequentially.

James Breen – William Blair & Company

Okay. And then just one question on the M2M or the business with like Caterpillar. Can you just talk about, as you guys are obviously providing the connectivity to these devices, and then there is other companies that are sort of providing some of the equipment that goes inside the machine to figure out what they want to monitor and how they want to monitor it, is there opportunity over time as more and more things get monitors in these devices for the per-piece of equipment amount of revenue coming to you guys to increase? Is it more of a variable bit rate type of service that you are providing there?

Matt Desch

I think our core business model is really growing the number of devices out there and adding incremental service revenues from new services. For our part of the equipment piece to actually increase would mean that we would be starting to do more of the solutions ourselves or starting to build in other functions, if you will, into that.

And, right now, again, our business model has been more to support a growing healthy ecosystem of partners and not to compete with them. And I think that wouldn't be viewed well if what we did is start to take away key functions – away from our channel.

I mean, I think one of the reasons why we are so heavily recommended and desirable in the satellite end-to-end space, is just that we are a pure play as it relates to being an operator and not starting to dabble into other functions that really our partners should be adding value to, and for which we could be chasing, but spending a lot of money and lowering our margins and perhaps having some misses there, too. So no, I don't necessarily say that I think that you will see growth in the equipment sector of that.

I will say I am pleased that our ARPUs are holding nicely in this sector. I would say we are kind of continually forecasting that there will be declines because bigger new applications often have less need for lots and lots of data. But we are not necessarily still seeing that to the rate we thought we would. And we continue to see very good ARPU stability, but that is not really the model going forward, necessarily, either.

James Breen – William Blair & Company

Okay. Thank you very much.

Matt Desch

Sure.

Operator

Thank you. Our next question comes from the line of Jim McIlree from Chardan Capital. Your line is open.

Jim McIlree – Chardan Capital Markets

Thank you. Good morning. I just wanted to clarify the R&D. So it is $6 million in each of Qs 3 and 4? Is that what you are expecting?

Tom Fitzpatrick

That is right.

Jim McIlree – Chardan Capital Markets

And does that go down in 2015 to something close to 2013 levels, or is somewhere between the 2013 and 2014 levels?

Tom Fitzpatrick

I would call it the latter, Jim. This is all NEXT related. As you know, we are in the peak spending on NEXT. And so as we are spending on the ground infrastructure and the satellites, we are spending on the terminals of the terminals goes to R&D just under GAAP. So we think it comes down from the 2014 level, which is the peak, but it's not down as far as 2013.

Matt Desch

Just to – by the way, when I say we are spending on terminals, just to not be confusing there, because I mentioned how our strategy has changed here. Instead of building like an OpenPort pilot type product for NEXT, when we talk about products being available in 2016, we are going to be selecting later this year a couple of different partners to be building those terminals.

And what this R&D is going for is in core circuit cards and modules that will go into those terminals that will sell to those companies that we select. But they are really going to design a wide variety of products and use their distribution channels to take those out to market, which we think will even grow our ability to expand our ability to have success in the broadband market with NEXT, but is all part of the NEXT program that we are spending.

But, as Tom said, because it is related to terminals, the accounting on that is different. And so it sort of pops up into this unique way because it has to go through R&D instead of through capital, I guess. Right?

Tom Fitzpatrick

That's right.

Jim McIlree – Chardan Capital Markets

Understood. Thank you. That's all I have.

Operator

Thank you. Our next question comes from the line Andrew Spinela from Wells Fargo. Your line is open.

Andrew Spinela – Wells Fargo Securities

Thank you. I was wondering if you could expand on your comment about the OEM wins sort of layering – being layered on top of the high teens strong growth that you are seeing in the base. I am just trying to understand really high level if these new wins are sort of evidence of an expanding market, that where you are seeing sort of high teens growth in a base that you are then going to layer on top some OEM growth, such that we could see an acceleration in growth. And is that acceleration coming from an expansion of the market or is it coming from the expansion of your share of the market? Any color there. Thanks.

Matt Desch

Yes. I think I got asked this question last quarter in a different way. But, the question is how much of it is in both those fronts. And I think I answered it, then, that I thought it was sort of split between a constantly growing market.

I mean, there are literally going to be billions of devices out there in the global Internet of things or machine to machine market. And it is called the expanding. And our – I think there is more and more applications for satellite connections in all that base.

And we believe we will get more than our share of that aspect, particularly because we have the best product in that sector. We have the least latency, the most coverage, the smallest antenna sizes, et cetera. And the heavy equipment OEM sector happens to be one right now that is in transition, both because they have moved – that whole sector has moved from what I would call the early days of initial trials and using telematics for some products to starting to accept that this is just a fundamental part of business. It is a core capability that has to be on everything going out the door.

And as they move towards that and make decisions, we think Iridium is going to get the majority of that kind of new business going forward. And there will be a transition there. So it is a sector, but there will be other sectors doing that as well over time.

So, both we are kind of increasing share while the overall market is increasing, and I think that bodes well for our potential in the M2M market going forward. I think we have talked broadly about how we think that this – I don't know if we'd use the word accelerating and that sort of thing. I guess we have said accelerating.

Tom Fitzpatrick

We have.

Matt Desch

But we do think that that will really bode well for our business in the next few years as we continue to bring more to the market and the sector expands. And we compete extremely well.

Andrew Spinela – Wells Fargo Securities

All right. I appreciate that color. Tom, much more specifically, the increase in Q2 and the cost of service – and maybe I missed your comments around it, but I guess it is related to some spending for the government service. Is that a sustainable or ongoing cost or will that sort of come back down in Q3?

Tom Fitzpatrick

So that moves with – the government engineering and support is episodic, right. So you are going to see cost of service – when the government engineering and support revenues spike, you will see cost of service spike in sympathy with that, because that is typically not very high margin work. It is in the 20% range. And so whenever you see a spike in cost of service, that is what it typically relates to. You look to the engineering and support revenue line.

Andrew Spinela – Wells Fargo Securities

All right, guys. Thanks a lot.

Operator

Thank you. Our next question comes from the line of Robert Hoffman from Princeton Opportunity. Your line is open.

Robert Hoffman – Princeton Opportunity Partners, LP

Good morning. Just a couple of quick clarifications. When you sell equipment to the government, is that going to show up just in the equipment line?

Matt Desch

Yes. All equipment shows up in the equipment line no matter who we sell it to.

Robert Hoffman – Princeton Opportunity Partners, LP

Got you. And, in terms of the new Cat, in the Cat relationship, you are called an exclusive satellite provider. Is it a similar situation here?

Matt Desch

I'm sorry; a similar situation to the new OEMs. Yes. No, we are not suggesting – we are not announcing that, let's say. It was not part of it to say that.

I think practically, in many cases, they are not going to be splitting their business up amongst multiple satellite suppliers. So we think that once we are built into the product, for all intents and purposes, it will be only Iridium connections that will be being made. But I am not trying to make announcements in quite the same dramatic way, because Caterpillar really did communicate to us and said it is okay for you to say that, though we haven't really heard that same thing from the other OEMs yet.

Robert Hoffman – Princeton Opportunity Partners, LP

Got you. And, in terms of the timing of Caterpillar – so do you have any sense of the lag between when you sell them a piece of equipment and when it is going to get into service? I mean, should we see – will we see – will it all be intra-quarter, do you think, where you sell a piece of equipment and by the end of the quarter, it is service? Or should we see equipment building in Q3 and Q4, and then revenue in Q1 and Q2 of next year?

Tom Fitzpatrick

It is really the latter. We might see some service revenue in 2014, but we have said that you will see the equipment revenue first in 2014 and then you will see the service revenue in 2015.

Robert Hoffman – Princeton Opportunity Partners, LP

Great. Got it. And when you talk about – previously, or earlier, you were talking about handsets volume; or I guess I am just trying to clarify – were you talking about volumes or you were talking about revenue? Because I would think if handset pricing comes down, that also affects your revenue, correct? So…

Tom Fitzpatrick

We don't really see handset pricing coming down. I mean, if you say handset, the GO and the new product is priced lower than our traditional handset, but our handset pricing has been pretty stable.

Robert Hoffman – Princeton Opportunity Partners, LP

But you don't breakout handset anyway, right? It is all in equipment.

Matt Desch

Right. We don't break it out. I mean, our M2M pricing has come down over the last couple years. In fact, kind of trimmed our prices there a little bit, not so much dropping them lately, but not charging really high levels for just a few products. And so there is a lot of mix issues there.

But handsets, by the way, just specifically, we haven't changed that much over the last couple years. And, if anything, our competition seems to be increasing their prices as they saw that they couldn't compete well with us at low prices. So that has created some stability really there for us, I think. But Iridium GO! will add to that – will change the mix a little bit, too.

Robert Hoffman – Princeton Opportunity Partners, LP

All right. Thank you.

Matt Desch

Thanks, Rob.

Operator

[Operator Instructions] And I have a follow-up question from the line of Chris Quilty from Raymond James. Your line is open.

Chris Quilty – Raymond James & Associates

You didn't talk about the aviation opportunity, and I have seen a couple of announcements from Honeywell and live TV with new antennas and new systems. Can you give us an update on where that part of the business is going?

Matt Desch

Yes. I mean, aviation continues to – it is a smaller segment for us right now, but – and we don't break it out, per se, because it is really both in our core business and in our – the OpenPort type business. It is sort of expanding on both sides.

With the certifications that we have had a couple years ago, being able to provide safety services, more and more airlines are picking up Iridium because it is low-cost compared to the alternatives. And you are seeing a lot of announcements around that right now. We just had an aviation partnership sub conference about a month or two ago here, and the outlook was very positive amongst all our partners who are in that space around putting the Iridium solutions onto commercial aircraft, in particular, though there is a lot of still growth in, say, the G&A sector, if you will, particularly like corporate jets.

And particularly we are starting to really get into rotorcraft lately. I am really pleased to see some – the first growth, really, I think in the OpenPort or higher-speed services is going to be in the rotorcraft, because Iridium works apparently very well underneath the rotor, unlike other systems. So we are starting to see some big wins there. We will start being fitted on bigger helicopter systems going out there. So it is really across the board.

Obviously, there has been a lot of press lately in terms of the Malaysia Airline loss and all the solutions of our partners that can provide tracking services or black box tracking or real-time tracking. Those are positive pressures, if you will, in terms of our expanding business on that front, and obviously leads to Aerion as well. So yes, it has been positive. But we just don't break it out enough to really give so many specifics that I guess I talked about as much this time.

Chris Quilty – Raymond James & Associates

Great, and final question on the OEM market. Can you talk about, with new customers, are they generally displacing an existing solution? Is it the fact that they have terrestrial and they just need the additional coverage of satellite? And on most of these opportunities, is Iridium going in direct or are you going through third-party equipment vendor that is integrating Iridium inside the solution?

Matt Desch

So, a couple of questions there; you know, it varies again based on the OEM. But, traditionally, it is a little bit of both. It is new business going forward. So obviously that could displace an existing supplier in terms of expectations for installations once they move over to Iridium.

But it is also, I think, there is an expansion really of their strategy into broader-based applications across more lines of their business. And that would be sort of just pure growth, if you will, in that space.

And the going together – we are almost always dealing directly in one way or the other with the heavy equipment OEM, which isn't true of every sector in machine to machine. But, because most of them are so big they really want to deal with us in some way. In most cases they really – they want to be their own value-added reseller in terms of their own billing services. But in some cases they are looking to possibly work through one of our existing partners.

But almost – I mean, in every case, one of our equipment VAR or VAM partners are going to be in the middle of the solution, building our modules into that and providing additional value-added services. So our channel is heavily involved in the sales. But I hope that answers your questions.

I know you are probably trying to get to a bigger competitive situation, and I really don't want to push on that necessarily, because it is not exactly clear what that will mean going forward. We think, overall, the space is expanding. But, yes, we are getting an inordinate part of the heavy equipment piece of it, we think, going forward. Or we plan to, anyway.

Operator

We have no more questions in the queue. I would like to turn the call back over to the speakers for closing remarks.

Matt Desch

Well, thanks again. Good first half and we will look forward to seeing you all at the next quarter call. Take care.

Operator

Ladies and gentlemen, thank you for your participating in today's conference. This now concludes the program and you may all disconnect.

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