GeoEye (GEOY) is a company that specializes in building and operating satellites primarily used for imaging the earth's surface. The satellite's applications vary from public electronic programs, such as Google Earth and Google Maps, to high-security national defense operations for the National Geospatial-Intelligence Agency (aka NGA).
GeoEye has one major direct competitor in DigitalGlobe (DGI). GeoEye and DigitalGlobe were each awarded a 50% stake in the US Government's EnhancedView SLA project. I believe that the awarding of these contracts are also the primary root of Stephen Feinberg's interest and his recent insider buying in GEOY.
The result of this contract reward is important for comparing GEOY to DGI. DGI noted in their latest 10-k that this contract is worth $2.8 billion with about $20 million in monthly payments. However, GEOY stated that the contract is also worth $2.8 billion but with approximately $12.5 million in monthly payments. Along with this contradiction, DGI affirmed that they are not only getting higher monthlies but also higher increases in monthly revenues. This amount will be paid upon completion of the satellites that is built to the tune of $25 million to GEOY's additional $15 million. DGI's total share will then increase to $45 million in monthlies vs GEOY's $27.5million. This calculation of value can be seen as problematic.
How is the final result worth $2.8 billion to both companies? GEOY's smaller monthly payments may be the result of another existing contract (valued at $1 billion) between GEOY and the NGA. DGI was not awarded this project. In addition, GEOY also receive additional funding from the NGA to help with the costs of construction for the EnhanceView project. It does not appear that DGI received those same concessions in their contract.
At the time the contract was being awarded, NGA asked GEOY for a letter of credit to be available regarding the shared construction costs. This is a result of GEOY being more levered than DGI and was looking to the NGA to fund a portion of the costs. This requirement was withdrawn once the contracts were awarded. Prior to this change, in an attempt to fulfill the letter of credit requirement and increase their chances of winning the contract, GEOY partnered with Stephen Feinberg's Cerberus Capital as a signal of financial strength.
Even after withdrawal of the letter of credit requirement, GEOY was still obligated to sell 80,000 preferred shares with a face value of $1,000 each and a 5% annual interest cost. Those shares are convertible at a price of $30 a share. At 5% interest cost, Cerberus would receive $4 million per year. If shares go to $40, the preferreds would be worth about $24 million more. This financing has a serious expense being that in 5 years the cost of the preferreds could be closer to 7-8%.
Some combination of Feinberg's and Cerberus entities currently own about 2.4 million shares of equity in the company as well (he has since bought a little bit more at prices below $20). That equates to another $50 million equity investment. Feinberg has bought shares ranging in price from $20's to $40's with the average cost being over $30/share. This is key, as a $50 million equity investment versus $80 million in preferreds, makes it clear that the investment is no hedge or arbitrage play with the convertible preferred shares. It is pretty much a bet on the company being worth at least $30+ a share. Please refer to footnotes at the end of the article about Cerberus Capital's current investment position in GEOY since the combination of preferreds and equity purchases make it difficult to estimate the exact value of the position.
At $22 a share, GEOY market cap is approximately $500 million. Adjusting for $220 million in cash and $510 million in debt, enterprise value (EV) equates to about $800 million. Net income (NI) is projected to be about $45 million conservatively going forward. That leads to an EV/NI ratio of 17.5x. That is expensive. Since depreciation is a real cost and we are assuming fully depreciated assets are worthless (what do you do with a satellite in space after its useful life?), operating cash flows equals net income. Capital expenditures (capex) is primarily used for new satellites so I won't deduct that from cash flows. In 2011, it is estimated they will have about $300 million in capital expenditures.
With net income of $45 million, and an invested capital base of $980 million, GeoEye's ROIC is approximately 4.6%. Assume that growth rate on their capital expenditure program is $300 million per year; earnings should grow about $15 million per year over the next 5 years. This is a function of the EnhancedView contract (capital expenditure) multiply by a margin (ROIC), or $300mil x 5% = $15 million. After 5 years, net income should hit approximately $45 million + $75 million or $120 million total. Since the company would not have any significant increase in revenue until the new satellite is in operation, it would also be prudent for an investor to discount back the price from the effective date of operation for the satellite about 2 years out.
Assume a 10x multiple at $120 million to get an overall valuation of approximately $1.2 billion. Adjust for the preferred shares dilution, since our value is going to be above $30, by increasing the current share count from 2.7 million shares to 25.5 million shares. After adjusting for current net debt of $300 million, the result is an equity value of $950 million or about $38 a share. If you want to discount 2 years by a rate of 6%, the share value is $34 today. As such, at $22 it seems that the upside is at least 55% and upwards of 75% in about 5 years. Although by that time, if all of this speculation is correct, they can be valued at a premium as well.
DigitalGlobe is not really worth valuing right as it is uncertain how much profit will be flowing down. While they may be cash flow positive, they have been lacking meaningful profits. Since the satellites need replacing every 10 years as noted in both companies' 10-k and DGI's cash flow equals depreciation, the company in effect is a net 0 in terms of cash flow. If we apply the same ROIC equation above to DGI, the resulting valuation would come around an anemic $10 a share, which is below their current price of about $14.
There are several other firms to explore in the satellite business. Garmin (GRMN), TomTom (OTC:TMOAF), Nokia (NOK), Orbital Sciences (ORB) and Loral Space (LORL) all operate in some variations of the satellite business. Google (GOOG) alone has effectively destroyed the competitive value of Garmin and TomTom via its Google Maps application. Nokia and TomTom both acquired satellite mapping companies that Google no longer relies on. Nokia is also much more levered to building mobile phone handsets as suppose to satellites. LORL, is very much like GEOY, they both solely build and operate satellites, except that LORL focuses on communications whereas GEOY is focusing in on imaging. ORB is also in the communication satellite space, but also provides rocket technology for launching satellites and other related defense applications. As a previous investor in LORL, I'd argue that GEOY is in the same position today as LORL was last year in terms of valuations.They have competitive advantages, work with government relationships, trade cheaply, have uncertainty over contract awards, and are generally hard to value..
Some notes and caveats:
- Convertible preferred shares are not listed on the balance sheet
- The preferreds may have been exercised already (it's not very clear! But does not change the investment case)
- If they were converted, Cerberus looks to be holding about $50 million in equity of GEOY and no preferreds
- It also means that they likely sold some preferreds and/or stock at higher prices, since they converted to 2.7 million shares and they hold about 2.4 million shares now
- In addition my valuation would then be conservative by about 10-15% since I'm accounting for some dilution which has already occurred
- My valuation model is simplistic
- Model assumes a $300 million capex per year (that is unlikely for this business for 5 years and will probably trail down a bit as contracts get completed)
- There is only 1 other major competitor in the US and it is DGI
- There are several international competitors
- The US government is not likely to want to depend on foreign firms
- You need 2 satellites to cover the earth (think about some geometry)
- 2 companies with 2 satellites each is pretty good coverage, not to mention ancillary satellites in operation by the US government and other foreign operated satellites
- Unlikely that the US government will sponsor another competitor in the imaging program, ROIC is already pretty low
- A malfunction at one of the newer satellites would be a HUGE blow
GEOY has a larger total value contract, which spells better competitive position in my book. GEOY is utilizing more debt-type financing it seems, which should allow it to have higher returns
- Current Price: $24
- Conservative Fair Value Today: $34
- Upside from today's price: 42%
Long Term: Buy equity for +42% gain
Medium Term: Sell June 22.5 puts for a 6.5% yield in 3 months