Thesis:

I recommend a long position in the equity of DigitalGlobe (“DGI” or “The Company”) at $12.75 with base case price target of $19 (~50% upside) with downside risk that should be relatively limited. The market is panicked about potential budget cuts to their key government customer, but this hysteria ignores potential complications to any draconian budget cuts. Any budget cuts are unlikely to be persistent or dramatic because of broad Congressional and Administration support for the program (although some cuts are a realistic possibility). But, perhaps more importantly, even in the event of major budget cuts, downside to the stock should be limited. Even in disastrous and improbable levels of cuts, downside should be limited as a run-off of the Company or potential liquidation of their satellite fleet and equipment should more than cover current enterprise value which helps to frame downside risk.

Company/Industry Background:

• DGI is the largest commercial provider of satellite imagery. They have 3 satellites which capture images for government/defense and commercial purposes. The commercial satellite imagery industry is essentially a duopoly consisting of DGI and GeoEye.
  • Commercial satellite imagery fills a valuable niche in the Government’s arsenal. First, allows for additional imaging of areas for defense and intelligence purposes. But, unlike DoD owned satellites (whose images are automatically deemed classified and not readily sharable across government departments), images taken off commercial satellites are not automatically classified (although they can be) which means these images can be shared across government agencies. This advantage is a key benefit of the commercial satellite imaging industry.
    • For example, the military could not share images of domestic wildfires or hurricane destruction with Dept of Interior or FEMA which can hinder responses. In contrast, images off commercial satellites can be shared across government departments.
    • Additionally, the high resolution and broad imaging capability of DGIs satellites can provide resolution for objects <45 cm.
  • DGI is 75% done with construction of a fourth satellite which is scheduled to launch in ’13 and will be the most advanced commercial imagery satellite ever launched (and will replace the oldest of their existing fleet).
• Largest customer is National Geospatial Intelligence Agency (“NGA”) which serves as an anchor customer for commercial satellite imagery (ie DGI and GEOY). In 2010, the NGA issued a 10 year, $7.3Bn procurement program called EnhancedView (“EV”) which provided funding commitments to each company. DGI’s share of the EV contract was $2.8Bn in the form of a Service Level Agreement (“SLA”) and up to an additional $750MM in value added services.
• 60% of revenue is related to NGA while 40% of revenue associated with commercial sales and sales to foreign civil governments.
  • The Company also has a vast image library they have accumulated of nearly every space on the globe. ~25% of revenue is associated with simply selling images out of their library to customers like mapping services, real estate companies and internet portals (ie Google Earth), which is often sold in conjunction with related value-add data/image processing as well.  

Situation Background:

• Budgetary pressures and the opacity of the NGA budget (which is classified) have led to meaningful pressure on the value of DGI stock. In the absence of any clarity, the market has simply panicked. Given the relative lack of transparency around not only DoD budgeting, but NGA’s piece of that pie (not the mention any potential distribution of cuts bw DGI and GEOY) the stocks have meaningfully lagged broader defense 

                                         LTM Performance:                               Last 6 months performance:

DGI:                                        -51%                                                       -31%

GEOY:                                     -43%                                                       -18%

Defense Index ETF                    +4%                                                        +25%

Consensus/Variant Perception:

• Commercial satellite imaging is on the budgetary chopping block.
  • Not necessarily. While I don’t deny the real possibility of cuts (in fact, I expect them) the jury is still out on the certainty and magnitude of any potential cuts. OMB is expected to produce a report on the commercial satellite imagery industry within the next few weeks which may set the tone for Congressional/Pentagon negotiations over NGA appropriations. Current government policy is that a robust commercial sector can help supplement government efforts. This was an explicit policy under previous administrations and the Obama administration confirmed this policy with a “2+2” architecture which provided for construction of 2 government satellites to be supplemented by government support for 2 commercial satellites.
    • Additionally, there is strong Congressional support for the program. Interestingly, the support is not just around the usefulness of the program itself, but the private/public model it represents which has been touted as a replicable model.  http://www.spacenews.com/policy/111129-lawmakers-rally-behind-enhancedview.html)
    • Director of Nat’l Intelligence James Clapper (who oversees NGA) is the former head of NGA and has historically been a proponent of the commercial satellite imaging industry (although recent reports indicate his support may be cooling a bit).
    • Any eventual budget cuts are unlikely to be persistent and may only impact a few years of the 10 year authorization.
• NGA cuts would be devastating for DGI’s performance.
  • Not at all. While clearly cuts would be unwelcome, any changes to any portion of the EV contract trigger an ability for DGI to completely renegotiate the entire contract. If NGA decides to cut back on the program, DGI can claw back capacity that had been reserved for the government and re-sell that capacity.
  • Any cuts to EV would also allow DGI to ease up on capex a bit which would help FCF generation.
• Stock has material downside if EV program is cut.
  • I disagree. First, even assuming a 15% cut to EV spending for the remainder of the 10 year agreement, the stock is still trading at an undemanding 5x forward EBITDA (<4.5x adj fwd EBITDA).
  • Perhaps more importantly, the Company has meaningful asset value. While a liquidation is not a realistic possibility, it does help frame downside. Construction in process PP&E (a new satellite which is ~75% complete) is $350MM while book value of 2 of their existing satellites (which have 6 and 9 years of useful life remaining) is $660MM. This suggests ~$1Bn in asset value from the satellites alone (they also have $200MM in cash) so even giving 0 value to their other assets (ground stations, other PP&E etc) asset value is $1.2Bn v enterprise value of $900MM.
    • These are valuable assets and the most technologically advanced commercial imaging satellites in the world and even if the US government decides they don’t need the capacity, there is still likely to be a bid elsewhere.
  • Furthermore, in an unrealistic “nightmare” scenario where the NGA decides they don’t need most of their commercial satellite capacity and decide to cut half of the entire EV program from ’13 onwards (and reduce value-add purchases by half as well), management could eliminate growth capex and put the Company in run-down mode by simply operating their existing fleet and maintaining their commercial and international trends. Under that scenario, in the next 10 years, DGI could generate cumulative FCF of $1.2Bn which discounted back @ 10% would be worth ~$750MM on a PV basis (that also assumes zero residual value). That implies a stock price of ~$10 which is a helpful way to frame a disaster downside scenario.  

Valuation Scenarios:

Price Target/multiple assumptions (based off EV/EBITDA):

Risks:

• Some level of program cuts are likely in the near term. Newsflow around any cuts (or the OMB report due shortly) could put pressure on the stock. Unless the NGA program is completely decimated, I believe the downside protection provided by the current valuation serves as a meaningful mitigant.
• Operation risks are inherent in the industry. Launching a satellite into orbit is naturally a technically difficult process. The Company has ~$500MM in insurance on their existing fleet (and they will ensure Worldview-3 prior to launch), there is definitely a risk of satellite impairment. This is at least partially mitigated by the fact that impairment is just as likely on military or GEOY satellites which would increase demand for their product so assuming random distribution of events, DGI is more likely to be a beneficiary of impairment than a victim.  
• New competition. While the domestic market looks to remain a duopoly for the foreseeable future, international competitors (some backed by foreign government) are emerging. This is a real risk and bears watching, but the number of countries that can develop and launch advanced satellites is limited to a handful and of the ~15 imagery satellites currently publicly announced in some stage of development over the next 5 years,  only 1 seems to have comparable resolution capacity to DGI’s existing satellites (and in any event, the US government would likely never purchase capacity from foreign owned operators). Still, this has the potential to impact international business.
• Technology shifts. In particular, there is a risk drones erode some of the advantages of satellites. This risk is definitely a possibility and it is reasonable that drones will replace some of the functionality provided by satellites operating at high resolution. But it is important to note that much of satellites use is not to spy on what somebody is reading, but is instead to give a higher perspective image of larger terrain. This functionality is not as easily displaced by a drone. In addition, the fact that a satellite passes over the same part of the earth at the same time, every day, makes it much more useful to compare changes in areas over time. Drones also include greater operational risk (satellites don’t crash into enemy territory) and higher risk of communications interference/jamming which is an increasing problem for UAVs.