Timing The Temporary Monopoly - Initiating Coverage On Iridium

Summary

  • In this note we initiate coverage of Iridium (IRDM) at Neutral on a long-term basis.
  • The stock is priced to perfection and the company is highly levered, in a volatile market.
  • The company has a potentially bright future but it cannot miss a beat in execution if this stock price is to be sustainable.
  • Newsflow around actual and potential competition (Inmarsat, OneWeb, Starlink) may drive the stock price to offer short-term opportunities.
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DISCLAIMER: This article is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this article is not an offer to sell or buy any securities. Nothing in it is intended to be investment advice and it should not be relied upon to make investment decisions. Cestrian Capital Research Inc or its employees or the author of this article or related persons may have a position in any investments mentioned in this article. Any opinions or probabilities expressed in this report are those of the author as of the article date of publication and are subject to change without notice.

Background – The Notion of Temporary Monopoly

The titans of tech and telecom, those businesses which grow quickly to reach $1bn+ of revenues with high levels of operating margin and operating cashflows, and wide moats keeping their competitors at bay, typically do so by defining and achieving a position of temporary monopoly. Such a position leads to the extraction of monopoly rents – super-profits – from customers even whilst achieving strong revenue growth rates.

For a company aspiring to achieve such a position, there are typically three ways to achieve a temporary monopoly in an otherwise competitive market:

  • Regulation. Government policy which excludes other players from your patch. The best examples are the Baby Bell telephone companies established in 1984 when the FCC mandated the breakup of AT&T (T). Though the regulation has changed, it is those laws that led directly to the creation of behemoths such as Verizon (VZ).
  • User utility. Network-effect business models such as Facebook (FB) or Google (GOOG) tend to monopoly, as users flock to the venue with maximum liquidity. Each additional network participant brings marginal utility to potentially all prior participants, and vice versa.
  • Capital deployment. Capex-intensive business models can get to market first and establish market ownership ahead of competitors if their access to capital – and willingness to invest it speculatively – leads the competition by a sufficient margin. Uber (UBER) is probably the best recent example of this model.

Most monopolies are temporary because each route to monopoly contains within it the seeds of its own downfall. A change in public policy can happen quickly and take with it the excess profits made by a state-sponsored monopoly. Network-effect businesses have a tendency to domination that attracts negative attention from governments – we are just seeing the beginning of this in social media right now – that could result in a breakup or other limitation. Finally, businesses that fuel their monopolistic position with cash are vulnerable to their available capital becoming insufficient, when the credit market tightens or indeed simply when a better-funded and more profligate competitor comes along – not least because businesses with spending in their DNA usually find it tough to operate with a tighter belt.

Iridium – Winner of the Race to Provide Global Comms Coverage

Iridium (NASDAQ:IRDM) has defined and now occupies a potentially lucrative temporary monopoly. It is the only communication operator to provide truly “on-net” global coverage in L-band, high-reliability, low-bit-rate spectrum with a modern peer-to-peer satellite networking system. It does so with a modern satellite fleet of 66 active units and a further 10 redundant on-orbit units, which can be accessed via specialty voice handsets or data transceivers. The network configuration is advanced insofar as each satellite communicates with others in order to form a true network in low earth orbit (‘LEO’) as opposed to a “beam up to a high geostationary orbit (‘GEO’) / beam back to Earth” configuration that one typically finds among comms satellite operators. The network configuration together with the already on-orbit redundant satellites means that the business ought to be able to avoid the single point of failure risk that traditional architectures embody (see for example our manifold notes on Maxar’s current situation).

IRDMs current service portfolio is essentially divided into three parts: voice calls, low bit rate data, and value-added services. They will soon introduce a fourth service element, a broadband data offering branded Certus. The most material of the value-added service is the ADS-B airplane transponder monitoring service which is operated by Aireon, a related party company which IRDM owns alongside other shareholders including 2-3 international air traffic control agencies.

How Should One Value IRDM?

IRDM is a 100% pure-play space business. There aren’t many of them around. But if you consider IRDM’s business model, forget for a moment that space is so hot right now and permit yourself to be a little reductionist, it is a simple business at its heart. It borrows money and uses it to put a set of telecom towers in the sky. It charges customers to send radio waves from one tower to another. It attempts to spend as little as possible sending those radio waves. It develops in-house or with partners a number of value-added services for which it can charge more than simple carriage fees. It tries to get as many years out of its satellites as possible, until the devices’ capacity, configuration or protocol capability approaching its natural limits – whereupon it will raise money again, launch new satellites, rinse and repeat.

Sounds a lot like a wireless telecom carrier, right? Indeed that’s the school in which IRDM’s team was educated. CEO Matthew Desch is telco through and through, moving from software development for AT&T Bell Labs to commercial management at Nortel to the CEO’s desk Telcordia (a revitalized, commercialized reincarnation of AT&T Bell Labs). Thomas Fitzpatrick, the CFO, joined IRDM from Centennial Communications Corp (a carrier acquired by AT&T in 2009), and prior to Centennial was a manager at Bell Atlantic Corp, now part of Verizon (VZ). You can find similar backgrounds among the other top management team (here). So the DNA at the top table has carrier blood.

Let’s look at a couple high quality carrier businesses and see how they are valued.

Here we use EV to forward EBITDA ratio as a valuation - (that means equity market cap, plus debt, vs. the expected EBITDA for the next twelve months). We do this because IRDM is about to go into a period where its forward EBITDA will represent its capabilities much more than will its TTM EBITDA, because its new fleet was not fully operational for the last twelve months. Also for VZ, T and TMUS, the next twelve months’ EBITDA is relatively predictable too, so it seems a reasonable basis for comparison.

We can see that as a group, these high-grade carriers trade in the approximate range of 5.0 – 7.5x NTM EBITDA over the course of the last eighteen months or so.

Now let’s look at IRDM in that context.

It soars above the pack, ranging from c.9x to c.14x forward EBITDA over the period, currently sat at 12.8x.

So let’s think about what might justify that. Being in a hot sector isn’t a good enough answer.

For a company with any given business model, with a disproportionately high EBITDA-based valuation vs its peers with similar business models, the valuation can be justified. But that justification has to be from, say, faster earnings growth than the pack, or perhaps faster deleverage than the pack (deleverage means – cashflow pays down debt and more of the enterprise value is comprised of cash and equity value ie. more money is in shareholders’ pockets and less in creditors’ pockets).

Can IRDM justify this valuation? First, let’s look at earnings growth. We’ll use EBITDA to be consistent. If the above is rational, it must be that IRDM’s expected EBITDA growth significantly outpaces TMUS, VZ and T.

A good way to assess this is to look at a company’s EV/EBITDA/EBITDA growth ratio. Below we take analysts’ consensus expectations for EBITDA growth for these companies, take the three-year CAGR growth rate and use that to compare the EV/NTM EBITDA valuations for each. On that basis, IRDM and TMUS are valued much more cheaply than VZ and T. Whilst one could explain away the premium valuation of T and VZ on the basis of superior dividend yield, that looks a stretch.

So on EBITDA valuation, IRDM is what is known by some as a “show me” story. Which is short for – “show me the money”. The growth curve is steep and this means the market will likely show IRDM no mercy on a miss. For instance, IRDM’s estimated Q2 19 EBITDA is a full 20% growth on the actual Q2 2018 EBITDA. Looking at TMUS, the equivalent growth is half that, a 10% growth between Q2 19 estimates and Q2 18 actual. Plus, TMUS is a larger, more mature business and simply has more levers to pull to get to that level of EBITDA growth. Nonetheless, on a relative basis, if IRDM hits its numbers, its valuation isn’t out of line.

Let’s turn now to deleverage. As of the end of Q1 19, the leverage stands at 6.2x TTM EBITDA. That is a big number. We take management’s deleverage guidance from their Q1 call below (coupled with some estimates about the difference between “OEBITDA” and “EBITDA”).

Source: Company SEC reports, Ycharts.com, Author's analysis.

Our numbers will be out a little because of the EBITDA vs OEBITDA delta estimate, and potentially some preferred share impact too, but the key story here is that in order to reduce net debt by $94m, the arithmetic is that the company must be expecting to generate around $100m of post-tax, post-capex free cashflow between 1 April 2019 and 31 December 2019. Should it do so, that will go a long way to validating the business model.

How Temporary Is Temporary?

In the ordinary course of business, IRDM’s approach here is fine, in fact it is capitalism 101. Raise money, invest in capital assets, sell the usage of those assets, collect revenue and earnings, pay down the debt or preferred equity used in fundraising. Ride the monopolistic profits. Rinse and repeat.

But just as monopolies contain the seeds of their own destruction, so too does capitalism itself. How this manifests itself is not, as some would have it, a tendency to revolution or shift to some other economic order. No, the destructive zeal within capitalism is deflation. And very specifically the kind of deflation that comes when a well-funded, zealous capitalist comes to town, intent on entering a new market. The most perfect form of capitalism is the Internet – and the most brutal form of deflation is the type of margin destruction honed to perfection by e-commerce entrepreneurs. Just ask every high street retailer anywhere on the planet. It's a kind of price dumping that is perfectly legal and utterly loved by customers.

Unfortunately for IRDM, there are two Internet entrepreneurs peering in the window right now.

One, Elon Musk, just launched 60 pizza-box style, highly advanced, high-bit-rate communication satellites into LEO, from one rocket fairing. The putative Starlink constellation is expected to have thousands of such spacecraft in orbit once complete. Rather surprisingly, Musk’s company SpaceX launched this without having an anchor customer. The company recently raised c.$1bn of equity funding and it spending a goodly chunk of that putting up an IRDM-style network with zero expected revenue for a little while. Now, we have no doubt that the Starlink constellation isn’t what used to be called “telco grade” by, well, telco guys. It probably isn’t Department of Defense certified, which IRDM is and indeed IRDM has a monopoly certain kinds of DoD traffic. But think about it. Thousands of broadband satellites, with high bit rate global coverage, heavily equity funded. Launched on rockets owned by the same company ie. no margin pay-away on launch costs. Versus 66 satellites, low bit rate global coverage, heavily debt funded, paying away launch costs to third party providers. Something has to give. Either SpaceX finds insufficient business and gives up – or SpaceX has a different goal in mind entirely and isn't trying to eat IRDM's lunch - or IRDM has to lower its prices given its lower bit rate – or IRDM won’t get to take its “capex holiday” that it has talked about because it has to upgrade its network sooner than planned, so it won't deleverage as fast as expected.

We don’t know what’s going to happen but we do know that this is a risk to IRDM’s earnings over the next 2-3 years and it’s a risk to IRDM’s deleverage too.

The second Internet guy looking in the window, Jeff Bezos, looks like a friend right now. Amazon is working with IRDM to deliver AWS services at IRDM ground station locations, to distribute AWS services (compute cycles, database capacity, etc) globally with low latency. So far so good. But Bezos is also talking about a broadband constellation, and he also doesn’t have to pay a launch provider because his rocket company BlueOrigin can launch and operate the constellation. So he might stay a friend, or he might not.

Finally on the topic - the other big change in the market is the take-private of Inmarsat (IMASF, IMASY). The change in ownership is material to IRDM in our view, although right now it doesn't affect our view on the stock as set out above. We'll cover this in a subsequent note.

Conclusion

Can one make money from IRDM? On a long term hold basis we think the numbers above speak for themselves. In the face of earnings risk, the company is valued in line on a growth-adjusted basis with boring old T-Mobile. IRDM is priced to perfection and highly leveraged. That is likely to lead to some share price volatility around earnings time. So we think the way to play this is to wait for such an opportunity – we’ll report when we see a trade we believe in. Alternatively, wait for some fear to creep into the share price – perhaps once SpaceX commences Starlink operations or when Starlink hits the inevitable rollout snags – and maybe then a long-term buy will become possible. We hope so. As our regular readers know, we have a long-only, equity-only focus. We want our covered companies to do well. We aren’t here to talk down anyone’s stock or the prospects for their business.

Our Next Steps on IRDM

We will be continuing coverage of IRDM as we do the other stocks in our coverage universe – pre-earnings preview and post-earnings review, every single quarter; updates on notable events; and ad hoc notes from time to time as we speak to management. We want to look more closely at their planned broadband service and their value-added service to see if that changes the story. (Our experience in telco suggests it will not, but it would be unfair to judge ahead of us doing the work). Plus, IRDM isn’t that big a business and it is far from out of the question that it could be acquired – this is something else we’ll turn our eye too and report back on.

Cestrian Capital Research, Inc – 29 May 2019.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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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.

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