I first became interested in GeoEye (GEOY) after reading a blog entry over at Old School Value, and was especially attracted by the fact that GeoEye’s major customer is the federal government, which makes its earnings especially resistant to the current economic downturn. However, at that time, the stock price of GEOY has soared after the successful launch of its GeoEye-1 satellite, and I felt that the buying opportunity has passed. Now that GEOY has again declined to attractive levels, I have completed an analysis of the stock.
GeoEye sells high-resolution satellite and aerial imagery to the US government, foreign governments, and businesses. These images are used by the government for national security purposes, meteorological/agricultural/scientific research, urban planning/land-use studies, and by the private sector for internet/GPS mapping, commercial fishing, and oil and gas exploration. GeoEye’s assets includes 3 satellites (GeoEye-1, IKONOS and OrbView2) and a small fleet of airplanes, the ground control stations required to operate and download data from the satellite, as well as processing centers which convert the raw satellite data into usable images. GeoEye has recently completed the launch of its most advanced satellite, GeoEye-1, with a resolution of 0.41 m, which is downgraded to 0.5 m resolution for commercial use due to DoD regulations. GeoEye’s main competitor is DigitalGlobe, a private company with satellites capable of providing images of comparable resolution to GeoEye-1.
After 9/11, the Bush administration vastly expanded investment in the intelligence services. At some point, a decision was made to outsource a portion of the satellite imaging capability of the government to the commercial sector. Although the US military and intelligence agencies already possess satellites with higher resolution than available commercial satellites, the NGA set up the NextView program, with the aim of supporting the development of two competing private providers of high resolution satellite imagery as a backup for the US government. GeoEye and DigitalGlobe were the winning bidders of the NextView program. The NGA has provided about $220 million in grants towards the construction of the GeoEye-1 satellite (costing $503 million in total), and has just signed an agreement to spend at least $150 million a year to purchase imagery from GeoEye. The NGA purchases imagery for a variety of US government agencies, including the Department of State, the Department of Transportation, the Department of Agriculture, FEMA, NASA, and the EPA, among others. NGA is GeoEye’s largest customer, accounting for 55% of revenues in 2007.
GeoEye’s largest commercial customer is believed to be Google, who has an exclusive contract with GeoEye for using its images for online internet mapping. Google’s founders are reportedly besotted with GeoEye-1, going so far as to be present at the launch of the satellite, and affixing Google’s logo on the launch vehicle. Despite this public display of ties, the word Google does not appear in any of GeoEye’s annual or quarterly reports, and the value of Google’s contract to GeoEye is unknown. In addition, Google’s recent spending and manpower cuts have raised the possibility that Google may seek to postpone or eliminate the planned use of GeoEye-1 images.
In the longer term, there is a risk that a change in the government policy of supporting the commercial satellite imaging industry may severely damage GeoEye. An independent study on the role of commercial remote sensing in the future of national geospatial intelligence commissioned in 2007 by the NGA and NRO suggested that the government not become completely dependent on the commercial sector for critical satellite intelligence data, and instead rely on the commercial sector only for non-critical lower resolution images. If the incoming Obama administration decide to reverse the outsourcing spree of the Bush administration, it is conceivable that the funding for GeoEye may be reduced. However, I consider this is a low probability event, because it would be devastating for the entire industry, and the government probably has an interest in promoting civilian use of high resolution satellite imagery, much as it has promoted civilian use of its GPS satellites.
Another major risk is the possibility of catastrophic equipment failure resulting in GeoEye-1 being non-operational. This is more than a theoretical risk; GeoEye had previously experienced just such a catastrophic failure with its now defunct OrbView3 satellite, and GeoEye’s bondholders have required the company to purchase $270 million worth of insurance against just such an event. In the event of satellite malfunction, GeoEye is not in a position to mount a spacewalk to repair the satellite, and the entire investment will have to be written off. However, it should be noted that GeoEye-1 is a more advanced satellite compared with OrbView3, and has duplicate redundant electronics which is more resistant to failure.
GeoEye is the typical capital-intensive operationally leveraged business. It has high fixed costs, but once those costs are covered, marginal earnings drop directly to the bottom line. GeoEye has $250 million of bonds issued at a staggering 13% plus Libor, translating to an annual interest expense of $35-$40 million (part of which is capitalized as the book value of GeoEye-1, accounting for the low figure in the income statement). I estimate its annual capital and salary expenditures to be around $100 million, and total annual expenditures inclusive of interest will probably run in the range of $125 to $150 million. I believe that the NGA has deliberately priced its contract at $150 million to cover the running expenses of GeoEye. Any additional business above and beyond NGA will translate to pure profit for GeoEye. However, GeoEye’s management has been infuriatingly uncommunicative on the company’s earnings prospects beyond NGA. GeoEye has 2 announced contracts, one with Google for exclusive use of GeoEye-1 imagery in internet mapping applications, and the other with Telespazio (a European satellite company) for resale of GeoEye images in Europe. The value of both contracts have not been announced.
In 2007, the company derived $100 million of revenue from the NGA, $65 million from foreign governments, and $15 million from the private sector, for a total of $180 million in revenue, and about $30 million in net income. In 2008, the company is expected to come in with $110-130 million in revenues, the shortfall being due to the delays in the launch of GeoEye-1. With the availability of higher resolution images provided by GeoEye-1, revenue in 2009 is likely to be higher. If GeoEye derives $70 million in revenue from foreign governments, and $20 million from commercial companies, GeoEye will have $90 million in annual earnings, or about $5 per share. GeoEye-1 has a useful life of 7-10 years, and the company is in the initial stages of designing and contracting for the manufacture of GeoEye-2. For simplicity of analysis, let us assume that cashflow drops to zero after 10 years, and the company liquidates for zero value. (A full-blown analysis requires knowledge of how much GeoEye-2 costs, whether the government will again subsidize the construction of GeoEye-2, and whether management prefers to use the cash flow to retire debt or to finance the new satellite. Basically, there are too many unknowns for a meaningful answer, so I prefer to analyze GeoEye-1 on its own merit and put off analysis of GeoEye-2 until there is more information.) In this scenario, with a discount rate of 10%, I arrived at a PE multiple of 6, or about $30 per share. Hence, by this analysis, GeoEye is currently trading at a staggering 50% of intrinsic value.
Which then begs the question, why is GEOY trading at such a low value? The short-term fear is that GeoEye-1 is having problems completing its calibration process and getting certification from NGA. In addition, investors have become very jittery after the launch of GeoEye-1 was postponed several times. Lastly, the stock is not very liquid, and there are signs of market manipulation around options expiry dates. However, CEO O’Connell just purchased about $100k worth of shares at $15.93 on 19 Dec 2008, and currently holds 179k shares. (His annual compensation is around $1 million, with half in cash and half in restricted stock and stock options.) This, together with the fact that GeoEye has new job openings, strongly suggests that GeoEye-1 is on track to complete certification. I feel that GEOY is a solid buy below $18, and has a minimum value of $25 to $30. However, due to a small risk of catastrophic failure and permanent capital impairment, I would limit myself to a small position.
I currently hold a small position in GEOY, with an average PPS of $17.50.