Echostar (SATS) Write Up

Recommendation: Buy

Stock Price: $25

Fair Value Target: $35 or Higher

Bull Target: $50

Bear Target: $18

Market Cap: $2,038MM

Average Trading Value: $4.7MM per day

Description

Echostar is a satellite leasing, set top box technologies, and broadband satellite company which was spun out of DISH Network in 2008. In June 2011, SATS acquired Hughes Communications, which operates satellites for broadband communications. SATS operates in three divisions: Echostar Services, which leases satellites, mainly to DISH; Echostar Technologies, which sells STBs including Slingbox; and Hughes. Charlie Ergen, the Echostar Chairman and Founder of DISH, owns approximately 44% of SATS equity and 56% of the voting rights. In addition, he owns approximately 54% of DISH equity and 90% of DISH voting rights.

Thesis

SATS is an undervalued, underfollowed, and hard to understand stock. SATS previously had no investor relations and does not provide guidance or non-GAAP clarity. As a result, SATS’s complex financial statements make the Echostar business seem unpredictable. However, when properly analyzed, SATS generates substantial FCF and has a clear growth path. In particular, the acquisition of Hughes adds steady, strong EBITDA/FCF growth over the next few years. Further, the new IR will provide investors, and potentially new sell side coverage, with clarity on SATS businesses. There are several catalysts over the next few months capable of revealing undervaluation: the launch of Jupiter 1, Hughes’s new +$300MM satellite; the growth of Slingbox as a popular 2012 consumer electronics item; and a set top box upgrade cycle from DISH as their Hopper/Joey STB system is rolled out.

Valuation

I value SATS on three metrics: NPV (DCF), Asset Value, and Breakup. I would rank them in that order.

NPV – To value SATS on a cash flow basis, one must adjust SATS earnings for deal related costs and amortization of intangibles related to acquisitions, which have a significantly negative effect on GAAP earnings but a positive effect, via lower taxes, on FCF. In addition, SATS has recorded GAAP taxes despite GAAP operating losses due to capital gains taxes related to their profitable investment in Terrestar debt. In addition, SATS has NOLs and accelerated depreciation credits that will substantially reduce cash taxes over the next few years.

To estimate SATS’s present FCF generation, I annualized SATS Q3 earnings after adjusting for deal related costs and amortization of intangibles. I then ran various growth and discount rate assumptions. I believe annualizing Q3 earnings is sufficiently conservative as Q3 is a seasonally weak quarter, DISH had excess STB inventory for the past two quarters, and SATS earnings should expand significantly in 2012 and 2013.

Note: My NPV calculations use a DCF based upon FCFE.

In a no growth scenario with zero value assigned to cash and marketable securities, I calculate a fair value of $13.15 and $10.86 at a 12% and 15% cost of equity, respectively. Importantly, this scenario gives no value to SATS’s $1,734MM of cash and marketable securities. While SATS has significant debt ($2,398MM) and large growth capex needs, it is doubtful all of their cash and securities are necessary as part of working capital. SATS’s combined capex and working capital needs have not exceeded $350MM in any year of publically available data. If we were to assume 50% of cash and marketable securities are available for distribution to shareholders, it would add $9.85 per share in value. Thus, at a price $21-$25, SATS stock reflects a no growth scenario despite a history of growth and large growth opportunities. (Note: If SATS were to use its cash to pay down debt, the 12% and 15% cost of equity scenarios would yield $21.68 and $17.81).

Assuming 10% EBIT growth (basically just mild Hughes growth) that trails towards 2%, yields $28.57 and $21.97 at a 12% and 15% cost of equity. A more bullish, yet still conservative, scenario of 15% EBIT growth yields $38.39 and $29.06. Again, these valuations give no value to the $19.70 of cash and marketable securities and are calculated after interest costs.

SATS appears unstable due to its complex financial statements. However, SATS generates strong FCF at present and has several strong growth opportunities over the next few years. Assuming the modest 10% EBIT growth scenario and two years of peak capex needs required in cash, I value SATS between $34 and $40 per share. A successful launch of Jupiter 1 and strong ramp of rural broadband subscribers would warrant a $50 or higher valuation.

Asset Value – SATS is difficult to value on an asset basis as this requires assigning value to Echostar’s satellite fleet. There is little comparable information available; it is calculated on a per case basis and rarely done. SATS has a TBV of $17.77 per share. Orbitting satellites are a scarce resource and public pure play satellite companies (VSAT, LORL) typically trade at a significant premium to TBV. Furthermore, book value for satellites are calculated pre-launch and a functioning, orbiting satellite is likely worth more than one on the ground. In addition, several of SATS’s satellites are still in use though they have been fully depreciated. I believe TBV is a sufficiently conservative asset valuation.

Breakup – A breakup is unlikely given SATS’s cash flow generation and majority owner Ergen’s long term outlook. However, for argument’s sake, I provide one. Assuming a 25% discount for Hughes relative to where SATS purchased them in June, 4x EBITDA for the residual SATS business ex-Sling (versus VSAT at 10x EBITDA), 8x EBITDA for Sling, and book value for their remaining cash and marketable securities, I value SATS at $31.91. Sell side break up values are in the $40-$50 range.

Catalysts

Jupiter 1 Launch – In Q2, SATS will launch Jupiter 1, a state of the art +$300MM Ka-satellite that will increase Hughes’s capacity by 1.5 MM to 2.0MM subscribers versus ~0.6MM customers today. While fully insured with a high chance of success (greater than 90%), the launch is both a catalyst and a risk for SATS. Satellite stocks typically rally into a launch, and the results of the launch will move the stock. A successful launch will add $300MM to $500MM to annual EBITDA, conservatively. Compared to SATS 2011 adjusted EBITDA of ~$500MM, Jupiter 1 represents a tremendous growth opportunity. Importantly, I believe SATS stock currently represents a no-to-very-low growth scenario. A successful launch should significantly enhance the NPV of SATS and a failure is already priced in. (Not that the stock won’t sell off the next day if the launch fails…)

Slingbox – Slingbox is a device and technology that enables consumers to watch their television via the internet on any device (computer, tablet, cell phone, other TV), anywhere in the world. While the company has owned the technology since 2008, the proliferation of smart mobile devices and the increased download speeds create a favorable backdrop for increased growth. At CES 2012, SATS announced a deal with Broadcom to incorporate the Sling technology in STBs available in Q3 2012. In a December 2011 interview, the CEO of Best Buy described Slingbox as his favorite new technology. Cable providers have typically been cool towards Slingbox as it was owned by one of their rivals, Dish Network. However, given recent disputes with content providers over television versus streaming rights, some MSOs, such as Time Warner, have warmed to Sling. The growth path for Sling is not certain, but SATS is not pricing in any growth and if Sling becomes a hot item, SATS shares would benefit.

STB Upgrade Cycle – At CES 2012, DISH announced their new set top box system, Hopper/Joey, which will be made by SATS. Over the past few quarters, DISH has been saturated with STB inventory and SATS equipment sales have slumped as a result. The announcement of an upgrade cycle by DISH, while relatively immaterial to an NPV calculation, should provide a modest medium term catalyst as a fundamental headwind shifts to a tailwind.

Earnings Clarity – While unimportant to an NPV valuation, GAAP earnings and the consistency and clarity of GAAP earnings often drive stock prices. In the case of satellite stocks, such as LORL and VSAT, many investors follow EBITDA given the large depreciation costs. SATS has previously frustrated investors with their unwillingness to provide clarity and to help the Street. However, two important changes should ameliorate this. First, the acquisition of Hughes, while complicated from a GAAP EPS standpoint, adds less volatile, strong EBITDA growth that should be more palatable to investors. Currently, due to the time lag between the Q2 launch of Jupiter 1 and the immediate interest expense/amortization expense from the Hughes acquisition, the coming clarity and consistency of SATS EBITDA growth is lost on investors. Over the next two years, SATS EBITDA will grow in a more stable and consistent manner than the past few years.  Second, after acquiring Hughes, SATS kept Hughes’s IR department. At CES 2012, SATS management indicated a modest commitment to increased investor communication. This increased communication should help more investors uncover the value in SATS.

Increased Sell Side Coverage – SATS is currently only covered by two analysts: Macquarie and Citi. As SATS has grown significantly in size since the Hughes acquisition, increased sell side coverage of the name is rumored and would likely be positive.

Risks

• Jupiter 1 failure
• Close relationship between DISH and SATS
• Sluggish STB business
• Continued transparency issues