|Shares Out. (in M):||87||P/E||0.0x||0.0x|
|Market Cap (in $M):||3,226||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||736||EBIT||0||0|
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Echostar Communications (SATS) is a very complicated satellite and technology IP holding company run by a good management team that is substantially undervalued today based on near term free cash flow and asset value at a 16% FCF yield on 2014 earnings. My price target is $62 or 70% upside at a 10% FCF yield (plus $7 in Dish Mexico value), given 10-12% core earnings growth. This name has been batted around the ‘value’ community for years but the stock hasn’t really done anything given no real changes in the business. I think that’s about to change given how much of a game changer their new consumer broadband business is.
In its original form, SATS was spun out of Dish Networks in January 2008 by the owner/manager Chairman of DISH, Charlie Ergen. At that time, SATS consisted of a set top box business (STB business), six owned and three leased Ku-band satellites (FSS business), Sling Media, an investment in Terrestar, 1.4 ghz spectrum, a Chinese satellite JV, DISH and SATS’ headquarters and $1.4bln in cash. Since then, the company has undergone many changes including the sale of its TSTR stake and spectrum, the launch of two new leased Ku-band satellites (and disbanding of one owned satellite), creation of a Mexican DBS JV and most importantly, the acquisition of Hughes Corp (HUGH) in Q2 2011 which consists of one owned Ka-band satellite, consumer, enterprise and telecom systems business segments.
Business Segments and Outlook
The most important business segment within SATS is the consumer broadband business, acquired through the Hughes merger. The consumer business utilizes satellite dishes, VSAT antennae and service to sell consumer broadband into underserved markets in all 50 US states, Puerto Rico and Canada. SATS has 60% market share while its competitor Viasat (through its acquisition of Wildblue) has 40% market share.
Over the past several years, a technology shift has occurred within the satellite industry allowing newly launched Ka-band satellites to have significant capacity advantages over Ku-band. The increased capacity allows for greater data throughput which increases the addressable markets for the satellites since more consumers are willing to subscribe to satellite broadband since speeds are comparable to cable. We’ve also seen subsequent launches by VSAT in the US, Avanti in the UK, Inmarsat in the marine broadband segment and the O3B constellation in the EMEA region for data backhaul. Given the same capex costs to build a Ka-band satellite as a Ku-band and the 10x capacity increase, the ROICs are significantly higher (assuming the increased capacity does not result in price wars). Hughes has signified that the capital costs of building their new Jupiter Ka-band satellites are about $4/gbps vs. Ku-band at $250/gbps.
The new Jupiter Ka-band satellite will have a capacity of 120-130gbps. They aim to increase speeds/customer in order to increase the size of the addressable market, targeting 3x speeds and 4x subscriber capacity or 2m subscribers on the satellite vs. their older Spaceway 3 satellite.
B. TAM Increases
With the increase in broadband speeds, SATS and VSAT can increase the size of the addressable market in North America. At a $450m capex cost to build Jupiter (and minimal incremental fixed costs) and total capacity of 2 subs, the buildout cost per subscriber is in the hundreds of dollars range vs. thousands of dollars for wireless/wireline per home passed. As we’ve seen with 3G wireless, the wireless carriers have no incentive to build out LTE networks to rural areas so we will not see any additional competition for at least another 6-7 years, if ever, given the cost disadvantage. In terms of the market size, the FCC estimates of the 130m households in the US, there are 109m homes passed with terrestrial broadband, of which 73m or 67% have broadband service. Of those, 51m have speeds greater than 3mbps and 22m have speeds below 3mpbs. 36m are underpenetrated (i.e. have the ability but have not opted for service) and 21m are completely underserved by broadband. Viasat and SATS are the only alternatives for those 21m, of which, their current market penetration is 5% or 1m subscribers. With Viasat-1 up and Jupiter now launched, available capacity will be 3m, still leaving a sizeable addressable market in the US and ensuring limited pricing competition, especially given the duopoly market structure. Based on conversations with people who live in underserved markets (rural areas of Pennsylvania, Vermont and the Adirondacks and Catskills) they are very excited to sign up for the new Ka-band service since there are no other alternatives for higher broadband speeds. Moreover, as continued video/data usage drives demand for higher broadband speeds, I can assume that with 22m households receiving dialup/broadband at <3mbps (5m on AOL/Earthlink pay $25 for service and another $10-20 for a second line), SATS service at 3-25mbps will draw subscribers from there, as well. The total addressable market here could conceivably be 21m underserved and 22m with <3mbps or 43m subscribers, total.
C. Consumer Business Growth/Margin Expansion
Much of the SATS growth story comes from revenue growth and margin expansion from the consumer business given the technological shift in the industry. In the consumer business, Hughes had historically leased Ku-band capacity at lower speeds and much higher costs. Based on my conversations with industry experts and the company, backing out leasing costs based on the company’s lease expiration info in their filings and guidance, I estimate 75k in annual consumer subscriber growth, 55% incremental consumer EBITDA margins in the business and flat ARPU as they shift customers onto owned satellites.
D. Jupiter Unit Economics
In assessing unit economics for Jupiter, if I assume current 2.2% churn and 75k net adds with all gross adds on Jupiter, $75 ARPUs, fully taxed (despite the company’s guidance that they will not be a tax payer for 4-5 years), and 40% pre-tax FCF margins (I tax this number based on straight line depreciation) I get to a PV of $1.6bln on a $450m investment, thus a very good use of capital.
E. DISH/Wildblue Contract Expiry
Dish has had a multi-year contract with Wildblue for wholesale broadband service on Wildblue’s satellite. Now that Hughes is owned by SATS, Dish’s sister company, the contract has shifted over to SATS. At Wildblue, DISH comprised 50% of wholesale net adds (which were 55% of Wildblue’s total net adds). Assuming this shifts to SATS, at the same numbers as Wildblue, this would add about 30k annual consumer net adds at a $30 wholesale ARPUs and an 80% incremental EBITDA margin (given no opex associated with wholesale customers).
The enterprise segment provides broadband connectivity, managed network services, ISP and hosted applications to a wide range of customers with a large number of points of sale/distribution in North America and internationally.
A. North American Enterprise
Examples include gas stations with 8-10k locations in the US, many in rural areas that utilize Hughes service and satellite dishes on each gas station’s roof to run software for accounting and transaction processing. Most of the service is sold through leased Ku-band capacity and is generally a boring but good business with 4-5 year contract lengths and 90+% renewal rates in the US. There are few alternatives for large companies with 4000+ points of sale (with many in rural areas) that need a fully managed network communication system. From some customer calls, Hughes offers a good service and given the significant cost to change service (mostly related to replacing dishes at every location), unless a massively cheaper wireless option is available, the customer base is very sticky. However, Walmart recently converted a small number of their stores from VSAT to terrestrial solutions, but for the most part, the enterprise customers here are very sticky. Given potential concerns of Walmart type customers, I assume about no revenue growth and constant EBITDA margins in the business (slightly below guidance and industry estimates of single digit growth).
B. International Enterprise
The international enterprise segment has significantly more growth than in the US, given its exposure to Brazil, India and China, In the international segment, the company also leverages its expertise in satellite infrastructure to offer networking services/VSAT equipment to smaller satellite operators such as Avanti, and Yahsat, further supporting management’s expertise in the business. In India, the segment operates in partnership with ICICI and Escorts, two very reputable companies (given ownership restrictions) though Hughes has control. Given the company’s scale purchasing of equipment, managed services know-how and limited alternatives in rural areas of Brazil/India and China, revenue growth has been in the low to mid teens and margins in the mid teens. I assume 10% growth and 14% EBITDA margins in the business going forward which is where the company has guided to pricing its managed services offering, internationally.
In its FSS business, SATS operates 10 owned and leased Ku-band satellites in North America where it sells its service to DBS providers (mainly DISH at 90% of revenue, Dish Mexico and Bell Canada). Given the limited incremental operating costs and maintenance capex, this business is highly cash flow generative at 70% incremental gross profit margins. While Dish Mexico is growing and the company has said they are selling service to new customers, growth has been tepid in the division on the current satellite base. Assuming no growth in current satellites, incremental revenue for their new satellite at $1.5m/transponder in annual leasing costs and 70% incremental gross margins, I get to 13% revenue and 17% gross profit growth in the FSS division next year.
SATS sells set top boxes mainly to DISH, Dish Mexico and Bell Canada. This business has been viewed very negatively by investors as potentially obsolete over the next several years given limited needs for set top boxes as smart televisions can simply perform all STB capabilities internally. However, I look at the STB segment as an IP business more than a commodity manufacturing business. SATS owns the IP behind Sling and Hopper and sells Sling boxes through the STB division. Sling has the patent on place shifting technology and given recent rancor between content providers and cables companies over what content can be stored on a consumer’s DVR vs. internally on the MSO’s network to be streamed to multiple devices, the value to Sling may increase over time. SATS recently licensed the Sling IP to Broadcom to sell in their set top boxes. Time Warner also announced that they will begin subsidizing Sling boxes for their highest end cable customers to bypass place-shifting IP issues. Charlie Ergen pioneered the multi-room DVR and has a 700 engineer base behind the business developing new technology to outsell Motorola’s and Cisco’s boxes and will continue to innovate beyond the current Sling based IP. In terms of near term financial impact, I assume the STB business does not grow revenue or margins going forward given limited gross add growth at DISH offset by substantial growth at DISH Mexico.
SATS also owns a 50/50 JV with Telmex (owned by Carlos Slim, one of the savviest investors in the world) in Dish Mexico. While financials are undisclosed, Dish Mexico has been growing its subscriber base at 40%+/year and is estimated to have about 3m subs, currently. While DBS providers in the US and in other developed nations trade at about $700-800/subscriber, ARPUs are about 50% lower in Mexico. I value Dish Mexico at $7/share.
SATS recently won two orbital locations in Brazil and has signified that they will setup a similar DBS JV to Dish Mexico with a local partner in Brazil. Post Echostar 16 launch, they may move a satellite to their newly won Latin American orbital slot to sell service to Dish Mexico and Dish Brazil. While I do not know who the partner might be, given their knowhow in the business, strength at Dish Mexico and STB/satellite capabilities, I can assume that the JV will be valuable while also increasing sales in their STB and FSS divisions. They have further signified that in the second orbital slot, they might launch another Ka-band satellite, Jupiter 2, to sell consumer broadband service in Latin America. Again, while we cannot estimate the financial impact to this near term, we are buying a great management team that will continue to profitably allocate capital in the future.
Based on the assumptions per segment discussed above, after backing out additional Echostar 16 and Jupiter capex and Brazil orbital slot costs from net cash, I arrive at 4.7x 2014 EBITDA and 16% FCF yield.
Reinvestment by a good management, Brazil…etc.
Charlie Ergen is the Chairman of SATS and has a 44% economic interest in the company. Charlie Ergen is a self-made billionaire who founded Dish Networks in 1980 and grew it and SATS to a combined $20bln in value. He has proven to be a very successful capital allocator and has been at the forefront of DBS in the US. It’s a widely held belief in the satellite/telecom industry that Charlie wants to use SATS as his growth vehicle for the future through the acquisition of game-changing technologies (such as Sling, though at $380m, the purchase may be too expensive, though we don’t know how much value will emerge out of the place shifting patents over the longer term), Dish Mexico, Dish Asia and Dish Brazil. His salary was $1 and he was not awarded any options in SATS in 2009 or 2010.
Mike Dugan is the CEO of SATS. He was previously the CTO and COO of DISH and was at the company since 1990 as it grew rapidly. He owns about $15m worth of SATS stock and collected a $750k salary but was not awarded any options in 2010 or 2011.
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