Satellite Industry's Tipping Point

by: Simeon Rusanov

A comprehensive review of the satellite industry's supply chain and dynamics within different segments of it.

Overwhelming extra capacity is expected to come to market by 2019; what risks and opportunities do investors face?

Remarks on SpaceX and OneWeb.

For decades the space industry has been an exclusive club of a few privileged market players. The dominant companies have split the satellite services into regions and applications, allowing them to act as monopolies in their niche subfield. Add the high entry barrier in the form of initial capital expenditure to the burdensome regulations and the lavish margins enjoyed across the industry doesn't look illogical anymore. In such an oligopolistic framework, the supply has been tightly controlled while the demand naturally increased as more and more technological applications came to life. As connectivity becomes 21st century's biggest achievement and field of ongoing development, more and more companies are turning their heads towards the sun.

The Ecosystem

Similar to smartphones, satellites are composed of power resistors, semiconductors and transmitters. As phones and computers are getting smaller and more efficient, so too are the satellites. The natural deflation in electronics is applicable to the satellite industry too, albeit at slower pace. Why so? The end product is still a low volume, highly customized equipment. The R&D per unit costs aside, the manufacturers themselves are enjoying generous profitability.

Leveraging on defense and aerospace expertise and product portfolio, the satellite manufacturing is a field restricted to Airbus (OTCPK:EADSY), Boeing (NYSE:BA), Lockheed Martin (NYSE:LMT), Thales (THALES) and few other multi-billion dollar companies. And it can't be otherwise. As EventShort's article makes clear, an annual volume south of 20 orders cannot support a specialized standalone business. Will the status duo change? Probability is rising but still quite miserable. On one hand, the field captures the attention of academics and other non-for profit organizations who are working on low-cost alternatives to the traditional technology. If such a project proves successful, it will quickly revolutionize the space and communication industries, reshuffling the value chain as we know it. Second, expected demand from projects like OneWeb might spur interest to new entrants. In either case, however, chances are the current players will adjust to the new environment and continue to dominate the industry. Yet until that point, the satellites will still come with a hefty price tag in the hundreds of millions.

Once ready for exploitation, the next step is to bring the satellite to orbit. While it might seem trivial, the launching could easily account for up to 30% of the mission's total budget. Whether you like him or not, Elon Musk deserves credits for modernizing the process and cutting the costs through reusable elements (goal is to reach 100% reusability by 2018). At the same time, as satellites get smaller and volume picks up, ride-sharing will most likely become industry standard. Once the deflation kicks in and absolute investment drops, investors will be more willing to take risks, putting further pressure on safety expenses. The snowball effect is evident.

Already in space, we can classify the satellites based on their orbit altitude from Earth. In the extremes, we have low earth against geostationary orbit. While demand for the end applications might be changing overtime, none of the technologies is superior to the other. The major trade-off between the two is cost versus speed (latency). The further away you go, the slower the signals are exchanged and the bigger the lag in communication (roughly 1/4 of a second for GEO round trip). On the flip side, the whole surface could be covered by as little as 3 GEOs as opposite to triple-digit LEOs.

The geosynchronous satellites are commonly used for one-way communication when speed of receiving the signal isn't that important. Applications include radio and television networks, direct broadcasting, low-resolution observation and weather forecasting. The purest plays in the field include EchoStar (NASDAQ:SATS), SES, Eutelsat (OTCPK:ETCMY) and Intelsat (NYSE:I) among others. Currently, there are more or less 330 GEO satellites, with a tendency this figure to remind unchanged or slightly decrease in future.

The low earth orbit satellites are a better choice when latency matters. Examples include telecommunication, machine-to-machine connectivity and data transfer and analysis. The LEO segment enjoys much higher attention from potential newcomers due to increasing applications and connectivity needs. The most exposed companies include Iridium (NASDAQ:IRDM) and GlobalStar (NYSE:GSAT). In terms of live capacity, the number of LEOs up-to-date is roughly a thousand with a high probability of dramatic increase over the next several years.

A logical question is if these two types of satellites are close substitutions to each other. While theoretically they might overtake each other's functions, it won't be the most efficient way of utilizing resources. LEOs for example, are not recommended for broadcasting purposes as satellites are constantly moving and it is harder for the antennas to capture the signal (as opposite to the static GEOs). Moreover, despite the recent advancements, the capacity of data transferred is still a major constraint. Hence, overloading LEOs with live streams will come at the expense of Internet and telephony applications.

The last building block of the value chain are service providers and manufacturers who rent the network from the satellite operators listed above. Constituent companies vary by industry and size, including large to small size broadcasting companies [DISH Network (DISH)], to airliners and maritime companies, to construction machinery (Caterpillar (CAT)) and niche service providers [Gogo Inc (GOGO) and Gilat Satellites (GILT)]. While the dynamics within these sectors differ by a margin, the segregation and specialization of the satellite operators makes end industry analysis worthwhile. Namely, Inmarsat, for example, is concentrated on maritime connectivity, while Eutelsat is dependent on the TV and media trends.

Risks and opportunities going forward

Starting with the challenges, future looks everything but bright for incumbents. First, for most applications the terrestrial infrastructure is clearly superior to what satellites could offer. Namely, the fiber optics generally accommodate wider bandwidth at a higher speed for a fraction of the investment required by a comparable satellite setup. Additionally, cables are easy to repair and maintain, have longer economic lifespan and are more resilient to hostile atmospheric conditions. Moreover, the dramatic increase in LEOs in orbit significantly boost the chance of collusions. And despite their heavy price tags, satellites are extremely fragile:

At orbital velocity, some eight kilometres a second, even an object a centimetre across could knock a satellite out. The more bits of junk there are out there, the more likely this is to happen. And junk begets junk, as each collision creates more fragments…
The Economist - Junk science

On the flip side, there are areas where laying cables is either impossible or not economical. For example, wireless is the only option for the aerospace and shipping industries. Additionally, wiring low-density rural or remote areas is unreasonable. The satellites are also faster to deploy and bypass all administrative problems a terrestrial network could face (e.g. land permits and labor intensity). Wireless data transfer is also generally more secure and hence preferred by governmental agencies. Following the increasing interest in the wireless technologies, the satellites are quickly improving, closing the gap between the alternatives. Hence, it won't be too bold to claim that sooner than later the space technology might be preferable to optics and copper. As evident, the current dominant players are viciously defending their positions by aggressively deploying top-notch technologies.

Satellite industry's biggest threat aren't Corning (GLW) or Prysmian, however, but Silicon Valley. As the long hanging fruits are already plucked, Mark Zuckerberg and friends shifted focus towards areas of low penetration. What's the common feature of all? Poor connectivity. Out of the sudden, Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Facebook (NASDAQ:FB) came up with the idea to provide limitless Internet to the world in exchange for secured growth going forward. So far, however, the one who are making the actual splash are SpaceX and OneWeb. Both projects are setting demanding targets - to double or even quadruple the number of satellites in low orbit. If any of the two succeeds, it will certainly put them onto industry's driver seat while dooming all traditional players. And these are not the only threats to the current oligopoly. In fact, 9 other companies have shown interest for LEO constellations operations. In addition to SpaceX, OneWeb and SES/O3b, the runners are said to include Boeing, ViaSat, Telesat, Audacy, Karousel LLC, Space Norway, Theia Holdings and LeoSat. The overwhelming supply is expected to start coming live by 2018-19, leaving little room for maneuvers to Iridium and the like.

Above all, OneWeb and SpaceX deserve extra attention. The first is backed by legendary influencers including Richard Branson, Qualcomm's (NASDAQ:QCOM) Chairman Paul Jacobs and the CEO of Airbus - Thomas Enders as well as SoftBank. Recently, the project is gaining traction: Airbus is actively working on the manufacturing, government approvals are present, and fund-raising has almost reached the $2b mark. Bottom line is, chances of successful realization of OneWeb are quickly converging one. Possible red flags are the recent slowdown in Airbus, headwinds for Qualcomm and Branson's sudden disposal of his stake in Virgin Group. The failed Intelsat deal might also be considered a negative development.

Surprisingly quiet, Elon Musk is even more dangerous. First, the scale of his project is bigger than the satellite industry and OneWeb's ambitions, combined. Second, he has the infrastructure (launching facility) and team ready to deliver. The funding shouldn't be a problem either - SpaceX is most likely profitable by now and enjoys a hype and loyalty comparable to Tesla. As we should all know by now, traditional economics doesn't work in the world of Elon Musk and Jeff Bezos. Profits aren't a factor anymore; all that matters are scale and market share. Musk has managed to disrupt or at least catalyze the trillion-dollar automotive sector - what are the odds for the significantly smaller and weaker space industry? Only possible shortfall would be a sudden breakdown of Tesla Motors.

Turning to the demand side of the equation, the picture isn't getting any better. The traditional broadcasters and cable networks are consistently losing ground to new platforms (Netflix, Amazon Prime and YouTube) while satellites are traded for Internet Protocol Television (IPTV). The only factors keeping the industry afloat are the slower technological adoption, exposure to under-developed markets and long duration of contracts in place. Going forward, I can hardly see what could get the industry back on track. In the meantime, the clock is ticking.

Traditional players' hopes and expectations are placed on the data-thirsty autonomous vehicles and IoT. While the automotive manufacturers are inconsistent in their views about connectivity, it all seems satellites are out of consideration. Volkswagen (VLKAY), for example, will most likely stick to 5G - a terrestrial-backed solution (at least for now). Tesla (NASDAQ:TSLA) will certainly use SpaceX's infrastructure if completed, while Google's Waymo might avoid Internet connectivity at all. In addition to the car itself, passengers' data usage will also increase dramatically as driver's attention will be off the road. The autonomous cars could definitely provide the desperately needed boost to the industry. Question is whether the satellites can realistically compete or be an integral part of the cellular network going forward. Similar argument goes for IoT.

A lone bright spot are the aerospace and maritime applications. In both cases, the satellite connection hardly has a viable substitution. At the same time, the unattainably high service price has left the two well behind. According to industry experts, this is about to change. In a recent report, a recognized industry consulting firm suggested the in-flight entertainment revenues to increase at a CARG of roughly 20% over the next 10 years. Possible beneficiaries include Panasonic Avionics, Gogo, Thales InFlyt, Global Eagle (ENT), Inmarsat and ViaSat. While the aerospace connectivity might actually undergo significant transformation over the following years, buying all these names might be premature. First, in markets facing secular decline (like the satellite industry in general), players tend to behave unpredictably. Hence, placing bets on the current subindustry leaders might be foolish - intraindustry dynamics will most likely change in the near future. Second, despite the positive macro climate, airliners are in a prolonged price war. In such an environment, it's hard to believe they will overpay for a service that is not considered a necessity or game-changer. Moreover, regulations could play a vital role in the technological adoption (e.g. the more restrictive the governments are for on-board device usage, the slower the market will unfold).

Final thoughts

While full of potential overvalued candidates, the space industry should be handled with extra caution. The vulnerable GEOs operators are sitting on broadcasting backlogs of sizes comparable to their market capitalizations. Additionally, in its latest press release Eutelsat expressed optimism regarding its video segment, expecting modest demand growth over the next 5 years. Public spending are also robust. The LEO operators, on another hand, are reportedly likely to partner with the new incentives rather than competing with them. In fact, Iridium and Intelsat are among SpaceX's largest clients at the moment. Industry consolidation should be considered.

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