Description

Situation Overview:

EchoStar (“SATS”) is an undervalued satellite business with significant incremental upside from hidden asset value. We believe the overhang exists as a result of: (1) misplaced focus on the set-top box business that is finally bottoming out, (2) a four year lull in satellite launches set to reverse with a robust launch pipeline, and (3) restrictions in management discussing several game-changing hidden assets, potentially poised for monetization.

SATS has been written up four times on VIC, so we are not breaking new ground here. However, we are struck at how different the situation is today versus the prior write-ups. The set-top box business now represents a minimal amount of the overall value, and the consumer broadband business is now well established with over 1 million subscribers. Instead, the overhang now is much more straightforward. Launch delays and an on-again and off-again M&A strategy have resulted in a three year holding pattern, creating fatigue among investors and an appearance of an also-ran to ViaSat among industry analysts. This has been compounded by a non-promotional management team that does not adjust EBITDA for one-time hits or stock-comp and until recently did not even put out a detailed press release with quarterly results. While the valuation has compressed to its lowest recent levels on both an absolute basis and a relative basis, the company has actually made meaningful progress behind the scenes, which is poised to show up in the results in coming quarters. Specifically, the company has made progress against three main areas: (1) accumulated $3 billion of cash ($32 of cash per share against a $39 share price) that we believe will be imminently deployed in the long-awaited transformational transaction, (2) set to launch 4 satellites, including additional capacity for its consumer broadband business, and (3) made significant progress in regulatory approvals for repurposing its pan-European spectrum for terrestrial purposes.

(Un)surprisingly, the point of maximum investor fatigue has set in just as the catalyst pipeline has become most attractive. With the stock currently in the high $30’s, we see upside to $60 on the core business, and several call options that could create multiples of further upside.

Business Description:

We won’t spend too much time on the company background given all the prior write-ups and discussion. Briefly, EchoStar originated as a spinoff from Dish Network in late 2007. At the time of the spin, EchoStar operated a set-top box business and owned a hodge-podge of satellite assets that primarily supported Dish. Over the last 10 years, EchoStar has transformed into a leading satellite operator and diversified away from its Dish exposure. Core EBITDA has increased from around $200 million at the time of the spin to $900 million in 2016 with all of the EBITDA gains in the more attractive business segments. However, given limited analyst coverage, complex reporting, and long-term oriented non-promotional management, the market still has the outdated perception and valuation of a commodity set-top box business. Today, EchoStar is a leading satellite company, operating across three business segments:

• Hughes (~50% of EBITDA): Operates the leading satellite residential broadband product in North America, serving 1 million consumers. Ka-band satellites, a relatively new technology, provided a step-function increase in capacity (up to 10x) over incumbent Ku-band solutions. Alongside ViaSat, Hughes has been one of the leading players to commercialize the Ka technology, displacing traditional solutions and opening up new markets for satellite, including consumer broadband. For residential broadband, Hughes offers download speeds up to 15Mbps, primarily competing against significantly slower legacy solutions. Hughes is able to create this capacity with upfront capex in the hundreds of dollars per sub versus wireline in the thousands. Hughes also provides managed services to large enterprises globally for mobile satellite systems. EchoStar acquired Hughes in 2011 for $1.3 billion and has since invested over $1 billion in capex to roll out new services.  

• EchoStar Satellite Services (~40% of EBITDA): Owns and operates a fleet of satellites for Dish, the U.S. government, internet service providers, broadcast news organizations, and private businesses. The primary source of earnings is providing satellite broadcast services for Dish’s direct-to-home (“DTH”) TV offering. While satellite TV subscribers are declining, the primary drivers for satellite demand and ESS revenue are the growing channel count and the level of resolution (e.g., shift to HD and ultra-HD).

• EchoStar Technologies (~10% of EBITDA): Designs and distributes TV set-top boxes for Dish. Management has launched two new products to help offset revenue declines in the legacy set-top box business. In 2015, the company began providing Streaming Video on Demand (“SVOD”) services for Dish’s Sling Product.
• Other Assets: SATS owns several assets that do not contribute EBITDA but still represent a meaningful amount of value. EchoStar Mobile has licenses to 15 billion MHz POP of pan-European spectrum that the company is working to repurpose for terrestrial use (more detail below). SATS owns 49% of Dish Mexico, a Mexican DBS JV with Telmex estimated to have around 3 million subs. The company is in the process of building out a Brazil business with a consumer broadband service (already launched) and a potential DTH service (awaiting the upcoming EchoStar 23 launch). Lastly, EchoStar is an investor in OneWeb, a planned LEO constellation, which Hughes will supply gateways and terminals.

   

Investment Thesis:

(1) Limited coverage and complex structure have allowed the misperception to persist that the set-top box business is still a significant component of value

In the first couple years following the spin, the set-top box segment accounted for roughly 50% of core EBITDA, creating the perception of EchoStar as a hardware manufacturer for Dish. Following the Hughes acquisition and significant growth capex in the satellite businesses, the Technologies segment only accounts for ~10% of EBITDA and a single digit percentage of value (as this is a lower multiple business). This is not a secret to anyone following the company closely, but still manages to weigh disproportionately on the valuation. Despite representing only 10% of EBITDA, ETC accounts for 40% of revenue and has caused frequent revenue misses as analysts struggle to capture the lumpiness and headwinds of the business. While this should not matter for the value of the business, fundamentally strong quarters have been no match for StreetAccounts alerts of a revenue miss. Even more surprisingly, sell-side analysts spend a shocking amount of time focusing on this segment. For example, after the company announced it was sitting on $3 billion for “satellite projects on a global basis as well as pursuing other strategic opportunities,” the first sell-side question was logically how to model to sequential change in ETC revenue. While ETC results haven’t been pretty, we do believe they have come closer to stabilizing, and street estimates finally capture the ongoing headwinds in the segment. This should help bring back focus to the segments that account for 95% of the overall value.

(2) A robust launch pipeline will reverse current headwinds on headline growth, earnings, and cash flow

Satellites businesses rely on new launches to support growth. The last major EchoStar launch was Jupiter 1 satellite in 2012. Over the last five years, the company has been preparing and investing in several new growth satellites. This lull in the launch pipeline has created a headwind on topline growth as well as reduced free cash flow as the company invests in the new satellites. However, these dynamics will soon reverse with 4 upcoming launches:

• EchoStar 21 will support a new MSS business in Europe and achieve key spectrum milestones

• EchoStar 23 will be a flexible Ku BSS satellite, potentially serving Brazil TV market

• Jupiter 2 will more than double US residential broadband capacity, which is currently filled up

• AMC-15 will offer Ku capacity to be commercialized in 2017

Over the last 4 years, the company has invested $2.6 billion of cumulative capex to support this launch pipeline versus a current EV of $4 billion. To be fair, some of this is maintenance capex (the company estimates annual maintenance capex to be less than $400 million year). Given the track record of successful launches and attractive returns on satellite spend in relatively low-competition markets, we are excited to invest in EchoStar at a time when the hard work and upfront investment has already been finished but not yet shown up on the income statement. In contrast to peers defending legacy technologies and struggling to grow, these launches in attractive markets will enable the company to return to growth and resume generating impressive free cash flow as launch capex declines.

(3) Management has been restricted in discussing several hidden game-changing assets, poised for monetization   

Charlie Ergen and the EchoStar management team have done an impressive job cultivating three hidden assets that could each individually provide significant upside to the current stock price.

1. S-Band spectrum being repurposed for terrestrial use with hemispheric coverage: EchoStar acquired a distressed satellite JV through which it gained licenses to 15 billion MHz POPs of pan-European satellite spectrum. This attractive mid-band spectrum (similar to AWS-3 in the US) is directly adjacent to spectrum already in use by wireless providers and was recently approved by the 3GPP standards board for integration into mobile devices.  Similar to Dish’s strategy in the US, the company is currently undergoing regulatory talks with individual EU countries to repurpose this spectrum for terrestrial wireless usage. Our understanding is that the company has already received approval from over half of the EU countries thus far, and anticipates completing regulatory approval process in the next 12-18 months. For obvious reasons, the company has avoided promoting the value of this spectrum while it’s in the process of negotiating with regulators. It’s tough to know exactly what fees the governments will require EchoStar to pay to repurpose the spectrum, but we believe there are scenarios where the spectrum alone is worth more than its entire market cap today.  Additionally, we have learned that the spectrum license provides an even wider band of potential terrestrial spectrum rights covering Africa, the Middle East, India, and other non-EU European countries.  While monetization of these additional regions is a longer-term event, this band may ultimately be worth as much as or more than the European assets. We realize there are diverse views on the value of spectrum and a lot of possible outcomes, but think at a minimum SATS’s spectrum is an attractive free call option.

2. Complicated asset swap transaction to increase dry powder for industry consolidation: In 2014, EchoStar and Dish executed a complicated transaction that resulted in EchoStar receiving a lump-sum of cash as well as a stable contractual stream of EBITDA to increase the company’s debt capacity. In exchange, Dish received an 80% interest in the Hughes broadband retail business. As a side note, while some were concerned at the time that Dish was looting SATS’ best asset, the retail business has generated minimal cash flow after paying EchoStar a wholesale fee for satellite services. We think the purpose of this transaction was to provide EchoStar with financial firepower to pursue a transformational acquisition that could result in one of the largest global satellite businesses. In July, management began using this untapped balance sheet capacity by raising $1.5 billion of cash, bringing the total cash pile to $3 billion ($31 per share). Management correctly predicted a couple years ago that there would be a shakeout in the industry, in part due to the new Ka solution of which the company was an early adopter. This has created an attractive opportunity for consolidation with several distressed public companies and several PE owned businesses coming up for sale. While the specific deal is difficult to predict, modelling out an illustrative deal at current satellite valuations and historical synergy levels would indicate upwards of 30% accretion to FCF per share as well as diversify the business away from Dish. Broadly, we believe there are three types of capital deployment opportunities for SATS: (1) tuck-in acquisitions of smaller players (ABS, Hispasat, Avanti, Telesat); (2) global platform acquisitions (Inmarsat, Intelsat); (3) JV’s to develop a global HTS (“high-throughput satellite”) fleet likely with SES or Inmarsat. Management publicly mentioned a focus on partnerships and helping rationalize the industry, suggesting the third bucket is the most likely. We have a tough time seeing them go it alone to add another greenfield HTS fleet. Instead, we think the most likely outcome is a JV with an existing player and perhaps adding a tuck-in acquisition for orbital slots or supplementing capacity. EchoStar 105 provides an interesting case study of SATS working with SES to commercialize a specific load on SES-11 with owner economics.  Alternatively, should the company not find the right deal, it would have ample capacity for a large share buyback.

3. Hidden investments in Latin American poised for inflection in growth: EchoStar has invested in several Latin American initiatives that now represent a significant amount of value but are often overlooked as they don’t yet appear in financial results. EchoStar owns a 49% stake in Dish Mexico alongside Telmex (owned by Carlos Slim) that is estimated to now have ~3 million subscribers and growing at double digit rates. Dish Mexico will soon be able to sell a broadband product since the launch of Jupiter 2 will provide capacity over Mexico. Management is limited in what it can say on Dish Mexico given its JV status and does not consolidate it for accounting purposes. We estimate the Dish Mexico stake could be worth up to $700 million or >$7 per share. EchoStar is also launching a consumer broadband product in Brazil, a DTH TV product in Brazil (potentially similar to Dish Mexico), and exploring other potential broadband offerings across South America with existing orbital slots. While it is difficult to model precise economics for what these new businesses ultimately look like, each could individually represent material contributors to the company’s financials with contained risk as the company partners with local distributors to offset upfront opex.

Competition

We have read the posts around ViaSat and skepticism of its business model. Overall, we agree that VSAT looks expensive on an absolute basis and particularly relative to SATS (trading at nearly triple the multiple). To be clear, ViaSat’s recent innovations have been impressive – we just struggle to underwrite this valuation as the company launches capacity into more competitive markets several years from now. Apart from valuation, there are two important distinctions between ViaSat and Hughes.

• Different Market Strategies: EchoStar has been more conservative on the value proposition of satellite broadband, focusing on rural customers without other broadband options. While this decision limits the ultimate TAM and makes for less exciting PR, we believe this strategy presents the most attractive risk/reward in terms of return on capital given the economics of existing competition and future competition (e.g., fixed wireless). While SATS may be focused on a more limited TAM, we still believe there is ample opportunity to grow their business.  VSAT and SATS maxed out select beams earlier than expected and have continued to grow ARPU suggesting ample market opportunity for this underserved population (8.4% of US homes lack access to 10 Mbps; 19.4% to 25 Mbps) even before new broadband applications. This rural strategy also reduces SATS’ exposure to segments of the satellite sector that will face additional capacity from the HTS launch pipeline.

• Wholesale vs. Retail: SATS sold 80% of its retail business to Dish and now just owns the wholesale business – operating the satellites and network in exchange for a fixed fee per broadband sub (~$27 per month). While the retail business (HRG) is consolidated for accounting purposes, SATS breaks out the economics of the retail business in its filings. Although the retail business generates limited free cash flow after hefty SAC, the wholesale business generates typical satellite margins and healthy free cash flow.

There has been a lot of concern when or even if SATS would launch a Jupiter 3, as well as over which geographic market. Based on FCC filings for the recent Spectrum Frontiers proceedings, EchoStar effectively acknowledged that there would be a Jupiter 3 in North America within the next 5 years, despite their refusal to admit any plans on earnings calls. It is tough to know exactly what Jupiter 3 will look like and how it will compare to ViaSat 3. However, at this valuation and SATS’ unique distribution relationship with Dish, we believe we are more than compensated for this risk. Backing out the other segments, the current market price implies a valuation for Hughes of less than 2x EBITDA.

Valuation:

There are a lot of moving parts in valuing SATS, with several initiatives where we do not yet have visibility into the exact offering. We think the best way to think of the situation as buying the core business at an attractive discount with several call options that could ultimately realize multiples of upside. Given the disparate business segments, we use a sum-of-the-parts analysis. For Hughes consumer broadband, we use a discounted cash flow analysis based on bottom-up estimates for Jupiter 1 and Jupiter 2, and probability weight several Jupiter 3 scenarios. The implied Hughes value represents less than 7x steady state wholesale EBITDA for Jupiter 1 and Jupiter 2 versus the closest comparable ViaSat trading at a low to mid-teens EBITDA multiple. As a sanity check, our aggregate Hughes valuation, including HRG and managed services, is ~7x current year total Hughes EBITDA. For EchoStar Satellite Services (“ESS”), we assume 6x EBITDA given the stable nature of the cash flow contractually guaranteed by Dish (one can almost think of these as a senior obligation of Dish) with growth initiatives in new markets already underway. Adding in the smaller assets (ETC, Dish Mexico), we reach a target price for the core business of approximately $60 representing >50% upside from the current price, also equating to ~6.5x aggregate EBITDA excluding the Dish Mexico stake.

As mentioned above, the European spectrum position and potential M&A could represent significant incremental upside. For the S-Band spectrum, we use a discount to several recent auctions in Europe (~$0.25 per MHz pop on an aggregate basis), equating to roughly $40 per share. There is potential for significantly more upside if European spectrum valuations converge with US values over time as the company believes (recent US mid-band spectrum auction would imply a value of >$40 billion for the EU spectrum). Additionally, EchoStar’s S-band license is unique—while it splits the S-Band position with Inmarsat in Europe, only EchoStar maintains hemispheric rights for the full 30x30 MHz block across Africa, the Middle East and parts of India. If the company is successful in monetizing these licenses, the non-EU spectrum value could alone represent tens of billions of value. It’s very difficult to know how much of this value regulators will try to claw back or if more challenging regulators like Germany will ultimately grant approval, but if nothing else, we believe represents an incredibly attractive free call option.

Lastly, we estimate an acquisition could add over $20 per share in value based on potential accretion from synergies and attractive debt financing. Alternatively, if the management cannot find the right deal, the company has debt capacity to repurchase well over 50% of its shares outstanding (the entire non-Ergen stake) with cash on balance sheet still running net leverage levels below peers. To put this in context, some satellite companies are levered at 4x EBITDA with mid-single digit yielding debt, while SATS currently trades at just over 4x EBITDA with a double digit unlevered FCF yield.

In total, we see upside to $60 on the core business with $40 of potential spectrum value and $20 of potential M&A value for a total target price of $120 if these calls options play out. This also excludes any value for the non-EU spectrum and limited value for the Latin America optionality.  

Catalyst

• Upcoming satellite launches
• Return to growth 
• Potential M&A transaction