Description

GOGO is undergoing a major business transformation from an owner and operator of a proprietary Air-to-Ground (ATG) network with respectable margins to a low margin reseller of Ku satellite spectrum. Simultaneously, the entire airline industry is shifting away from single-source in-flight entertainment and connectivity (IFEC) vendors with 3rd party brands to multi-source wholesale solutions in which the airline controls the end-customer relationship.  As a result, GOGO is encountering significant competition from well-funded companies that own their own satellite capacity and can provide airlines enhanced service at significantly lower prices.  These trends, among others discussed in this report, do not bode well for GOGO shareholders.

The short thesis can be summarized as follows:

• Despite historically dominant market share, GOGO is ceding share to competitors who are offering wholesale IFEC connectivity for ~39% below GOGO
• GOGO’s second largest customer, American Airlines, which comprises ~23% of total revenue is deinstalling GOGO on 550 airplanes that will simultaneously pressure aircraft equivalents and ARPA in GOGO’s North America segment
• GOGO is ramping 2Ku installs in its Rest of World (ROW) segment in regions where IFEC is not prevalent, spending massive amounts of CapEx with no insight into anticipated customer demand; this ill-advised strategy will result in ARPA dilution for the foreseeable future
• Downside optionality if/when GOGO’s single largest customer, Delta Airlines (~27% of revenue), explores multi-sourcing IFEC providers
• The Business Aviation segment, representing >100% of GOGO’s consolidated EBITDA faces headline risk from an upstart competitor, SmarktSky, which is launching a competing ATG network in 2018
• GOGO’s cash burn remains elevated and leverage is increasing, presenting a distinct possibility that GOGO is not a viable long-term going concern

Declining market share with unfavorable competitive landscape

GOGO insists that comparing average revenue per aircraft equivalent (ARPA) between IFEC providers is not a fair comparison because competitors act as a “dumb pipe” rather than as a full service leader in the connectivity space.  Despite this defense, GOGO is ceding share to competitors.  According to industry reports, GOGO has ceded ~1750bps of market share since the beginning of 2014, with total market share declining from 65.9% to 48.4% (as of 3Q17) over this time period. Contrast this to IFEC awards since the beginning of 2016, where GOGO has maintained the lead at 26.6%, but with share now split fairly ratably with Inmarsat (25.0%), Panasonic (21.6%), and ViaSat (19.2%).

This ongoing tectonic shift is being driven by competitors like ViaSat which offers wholesale IFEC service at an average annualized ARPA of ~$84k, ~39% below GOGO’s average annual ARPA of $139k (which also includes smaller regional jets with much lower ARPA). GOGO indicates that its mainline ARPA is actually ~174k/year in North America and $226k/year in its Rest of World segment, so ViaSat’s pricing is actually closer to a 51-63% discount to GOGO’s current offering in a true apple-to-apples comparison. Even for ViaSat’s higher end service, which includes full-suite connected aircraft, inflight entertainment, stored content, and internet/mobile flight operations applications, the annual ARPA is $144k which is still 17-36% cheaper than GOGO’s mainline ARPA in NA and ROW, respectively.

How is ViaSat able to offer IFEC at a significant discount to GOGO? ViaSat owns its network and is selling higher powered Ka-band capacity vs GOGO reselling Ku-band capacity. According to my field research, GOGO is re-selling capacity on Intelsat’s Epic satellite which has 14 Gbps throughput. ViaSat-1 alone provides 140 Gbps throughput (10x Epic’s capacity) and ViaSat-2 will offer ~300 Gbps throughput.  In addition to direct competition, deflating capacity costs should add incremental pressure on ARPA since GOGO has limited pricing power as a capacity reseller.

Lastly, my field research indicates that GOGO’s contract wins are largely due to the fact that GOGO is subsidizing equipment for airlines for which IFEC is not a priority and usage untested. Despite owning their networks and having lower cost structures, competitors cannot justify the economics of giving away free equipment with no visibility into end-customer usage. Indeed, it would seem difficult to justify the economics of giving away $200k+ of equipment on average for <$100k annualized ARPA at a ~50% margin.

American Airlines is already deinstalling GOGO which will pressure aircraft equivalents and ARPA

American Airlines and GOGO had a highly publicized tussle in 2016 that ultimately resulted in American filing a lawsuit against GOGO to end its contract. The lawsuit was subsequently dropped but resulted in American awarding 550 aircraft to ViaSat. Almost two years later, the retrofit process is finally underway and should ramp dramatically throughout 2018 in a much greater amount than is currently expected by sell-side analysts. Admittedly, one should view this skeptically as ViaSat only had 21 net adds to aircraft in service in the first three quarters of 2017 and has not had great visibility into the installation timeline which has been kicked out several times.

However, it is important to note that ViaSat does not control the timeline and has only committed to the delivery of the systems and IFEC service. American is responsible for the installation of the ViaSat systems through their MRO programs and is the one dictating the installation ramp. Despite the delays, ViaSat-2 is on schedule to launch service this year and American confirmed in Jan 2018 that the retrofit program launched in 4Q17. ViaSat believes there will be 100 deliveries in the March 2018 quarter and will ramp to a 150 quarterly run-rate thereafter, mostly focused on the American and Qantas portion of its backlog (American alone represents ~2/3 of the outstanding backlog). At this run rate, American will be fully deinstalled by the end of 2019 which will be a 550 plane headwind to GOGO’s aircraft equivalents over this period.  This represents nearly 20% of GOGO’s North America install base.

Another important aspect of the American deinstalls is that the 550 backlog consists entirely of mainline aircraft which have annualized ARPA of ~$174k. At the average mainline ARPA level, American will be a $10.1k/year headwind to annualized ARPA over the deinstallation period. In all likelihood, given American’s business-focused customer base, the American planes are probably above the average so the headwind could be even greater. My field research indicates that the remaining American fleet in the GOGO install base consist of older, aged aircraft and given that new American awards have gone to ViaSat, it seems unlikely that GOGO will recapture share within the American fleet.

GOGO could face double digit headwinds on CA ROW ARPA

GOGO has stated that they expect “meaningful” ARPA dilution as ROW aircraft ramp: “We continue to expect strong double-digit growth from our existing fleet, although consolidated CA-ROW ARPA is likely to be lower in Q4 and during 2018 due to new aircraft additions throughout that period.”

As GOGO executes its ROW backlog, the company will be installing 2Ku antennas for airlines like Cathay Pacific, AeroMexico, and LATAM where IFEC is not prevalent and where customers do not have the same level of experience or familiarity using WiFi/IFEC. Given this dynamic and GOGO’s lack of experience operating on these airlines, ROW ARPA could experience double digit declines in 2018, a far greater magnitude than analysts are currently expecting. Meanwhile, GOGO is incurring massive CapEx spend as they ramp installations in this segment without any clear visibility into ARPA.

Emerging competition in GOGO’s Business Aviation segment

The BA segment is GOGO’s wheelhouse. It is, by far, the Company’s most profitable segment, producing a robust 40%+ segment profit margin. There is, however, an emerging competitor in the field, SmartSky Networks. SmartSky is developing its own 4G LTE-based ATG network and has raised a quarter of a billion dollars, including a $170mm multi-tranche Series B round that was announced in March 2017. SmartSky claims it has a fully funded plan to build out the ATG network which was originally scheduled to launch in 2016, but is now anticipated to launch in 1H2018. It is in large part because of this delay that GOGO’s management and shareholder base have dismissed the competitive threat from SmartSky.

GOGO is skeptical of SmartSky’s efforts and believes the company is operating on a shoestring budget relative to what is required to build out a reliable nationwide ATG network. GOGO also points to the fact that SmartSky will be utilizing unlicensed spectrum that will likely cause interference issues (particularly around hub cities) whereas GOGO is able to use their licensed ATG spectrum along with unlicensed spectrum as needed.

In a recent development, SmartSky announced that the FAA has awarded Avidyne Corporation, SmartSky’s manufacturing partner, the first supplemental type certificate to use the SmartSky system on a Cessna Citation Excel.  Avidyne expects to receive Parts Manufacturer Approval from the FAA shortly, which is the last gating hurdle to clear for partners to complete their STC commitments on other aircraft models. I believe this announcement, more than any other, indicates that the competitive threat from SmartSky is not only real, but it is imminent. GOGO will soon be competing against a significantly faster network until its next generation ATG network is available.

Ultimately, it is unclear what impact SmartSky will have on GOGO’s BA segment, but it undoubtedly presents meaningful headline risk in GOGO’s most profitable segment. To the extent that SmartSky is a viable competitor, segment profitability could be pressured which is important since GOGO not only relies on BA segment profits to fund expansion in the Commercial Aviation segments, but management is also encouraging the investment community to use a sum-of-the-parts valuation, highlighting at the company’s analyst day that GOGO only trades at 15x BA segment profits.

Also worth noting is that GOGO’s BA ATG ARPA has been steadily increasing, partially as a result of old plans that were grandfathered in and are now rolling off as customers upgrade to newer, higher priced plans. GOGO has now largely lapped this upgrade tailwind and ATG ARPA growth should be muted as a result. To be clear, absent major competition from SmartSky, the BA segment will likely continue to produce steady results, probably in line with street expectations.

Downside Optionality from Delta Multi-Sourcing Announcement

GOGO’s single largest customer, Delta, representing ~27% of revenue, is the only major “non-budget” airline that has yet to publicly explore multi-sourcing, the process of procuring IFEC connectivity from multiple providers. It would seem like a fairly intuitive move for Delta to at least explore multi-sourcing to keep GOGO honest on pricing and terms.  In fact, a recent press release gaffe indicates that Delta is already exploring alternatives.

Delta issued an erroneous press release on 12/14/2017, implying that Delta would be using GOGO’s new 2Ku offering in conjunction with its purchase of 100 Airbus A321neos.

From the original press release:

“On-demand inflight entertainment, fast satellite-based 2Ku in-flight Wi-Fi, power ports as well as streaming video content will be available at every seat through Delta Studio.”

Delta quickly retracted the original press release after industry analysts construed this as a win for GOGO (GOGO is the only industry player that refers to Ku resale capacity as “2Ku”). Delta changed the language from the original release, which now reads:

“On-demand inflight entertainment, high-speed satellite WiFi, power ports as well as streaming video content will be available at every seat through Delta Studio”

To help clear up the confusion, Delta also issued the following statement: “Delta’s A321neos will offer high-speed satellite-based WiFi. We are evaluating proposals from several providers, including GOGO, and have not yet made a final decision.”

This remains a massive headline risk for GOGO and the fact that Delta felt the need to correct the statement indicates that multi-sourcing remains a distinct possibility. To be clear, it also seems unlikely that Delta would rip-and-replace the existing GOGO install base, but the notion that Delta is firmly wedded to GOGO would now seem in question.

In a May 2017 interview hosted by the Cranky Flier blog, the Delta CEO stated:

“The product [WiFi] we’ve had in the past, you can’t get more than 10 percent acceptance in terms of users. Their [GOGOs’s] model that they’ve had is they make prices more and more expensive so the more attraction there is to the product, the higher they raise the price to keep people from using it. It’s a terrible business model. And I’ve told them that. But that’s something that Delta has to own. We’ve got to own that relationship with the customer and we’re working, we’re not letting them intermediate anymore, we’re getting much more active. We’re managing our certifications and we’re managing the supply chain with them, on the ground, and we’re taking responsibility for the communications to the customers more and more. At some point, we’re going to have to figure out how to get GOGO at the same price-point customers expect the value is, which is free.”

Delta appears to be making good on this promise as GOGO released a free texting service on Delta flights at the beginning of 4Q17. GOGO has indicated that it expects some level of initial ARPA cannibalization but that increased engagement should drive ARPA over the long run.

“So we are compensated by Delta for the messaging pass. And yes, there will be some level of cannibalization of existing users, but we try to segment it. In most cases, you're still going to buy your session because you're going to send your big reports to everybody and you're not going to upload that on a messaging service. But we factor that in when we price something like messaging.”

In practical terms, the Delta free text messaging service is a superficial limit of bandwidth to a device, with the important distinction that GOGO has no method of regulating how customers use that bandwidth, whether for texting or for other purposes. GOGO indicated that customers can actually use this service for retrieving emails and other basic functions that don’t require significant bandwidth. As a result of this dynamic, it would seem reasonable to model an increase in take rate offset by a decline in Average Revenue per Session (“ARPS”) such that revenue per boarded passenger experiences a modest decrease. Under these assumptions, the Delta free text messaging product could easily introduce an incremental mid-single digit percentage headwind to ARPA for CA NA segment revenue.

Cash burn remains elevated and leverage is increasing

As is readily evident from a cursory glance at GOGO’s financial statements, the company continues to burn massive amounts of cash and leverage continues to increase with GOGO most recently raising an incremental $100mm of senior secured notes in September 2017. GOGO has consistently burned cash while net debt has increased in every quarter since the company went public. GOGO has gone from having a net cash surplus of ~$66mm in 2Q13 to having net debt of $587mm in 3Q17 (note the acceleration throughout 2016 and 2017).

As noted previously, GOGO is in the midst of a business model transition from a branded turnkey offering to an airline-directed wholesale model. This change is being driven by GOGO’s airline customers who are seeking to control every aspect of the IFEC offering with GOGO losing the ability to interact with the end customer. Despite the ongoing cash burn, GOGO likes to emphasize that 2017 will be its heaviest investment year with CapEx set to decline materially in 2018: “But the headline of that is that 2017, the current year, is going to be the biggest cash flow investment year and that will come down beginning in 2018, as we've guided to.”

While technically accurate, this representation is perhaps a little disingenuous as the decline in CapEx is being primarily driven by an accounting change as a result of this revenue model shift. Under the new airline-directed revenue model, cash outflows related to aircraft installations, which were previously classified as CapEx, will now be expensed as incurred on the income statement. The net effect is that while CapEx will decrease, the decline will be entirely offset by a commensurate decrease in operating cash flow such that there is no change to overall free cash flow.

When GOGO provided its updated Cash CapEx guidance in 4Q16 which resulted in the 2018 Cash CapEx guide declining from $170-205mm to $70-120mm, management noted that excluding the impact of the business model shift, Cash CapEx would only be $20-30mm lower than previously estimated.  What management failed to mention, and what I believe the market is missing, is the other $75mm+ of previously anticipated Cash CapEx is simply shifting up the cash flow statement to a cash outflow from operations.

Also worth nothing is that GOGO’s net leverage ratio is currently >10x on a TTM basis and will likely remain above this level for the foreseeable future, leaving little operational flexibility. Ultimately, while cash flow may improve modestly in 2018, I believe it is an unavoidable reality that free cash burn will remain well above historical levels with leverage continuing to increase.

Valuation

Consensus estimates for revenue, EBITDA, and net earnings have persistently headed lower since GOGO went public in 2013. The consensus estimates for 2018 EBITDA, for instance, was originally estimated at $501mm in late 2013 but has consistently dwindled lower over time and now stands at ~$100mm, which, based on the reasons outlined in this write up, I believe is still too high. The following table lists two segments of comparable companies: the first section is comprised of direct competitors operating in the IFEC market while the second section lists a number of adjacent telecom-related companies.

Using the lowest and highest of the averages above, I believe that GOGO should trade somewhere in the 8.3-11.2x EBITDA range off 2018 EBITDA. Based on my 2018 EBITDA estimate, this would yield a $1.12-4.09 share price, suggesting 58-88% downside from current price levels. It is worth noting that given GOGO’s ongoing cash utilization, the company will burn through an additional few dollars per share of cash in 2018 alone.  If GOGO is unable to double ARPA, which I believe is highly unlikely, and the company’s cash burn continues, the equity has the potential to be worth $0 over time.

Risks

Deinstalls happen at a slower rate: slower deinstalls will have the double benefit to GOGO of preserving ARPA and aircraft equivalents. However, even if delayed, the American deinstalls are a matter of when, not if, they occur and street expectations appear too high in the forthcoming years.

Monetization of BA Segment: GOGO finds a new way to monetize or highlight the value of its BA segment. To the extent investors use a sum-of-the-parts valuation on GOGO, the stock may appear undervalued and GOGO has recently been highlighting the fact that the stock traded at only ~15x the BA segment profit. It seems unlikely that management has any near term plans to monetize or divest the segment and, in fact, are dependent on its profits to finance the ongoing CA NA/ROW 2Ku installs.

Acquisition Risk: I believe the acquisition of GOGO would present limited strategic or financial value to any potential acquirer as a result of: GOGO’s continued strategy of becoming a Ku satellite capacity reseller vs. the owner/operator of a proprietary ATG network, the ongoing shift from being a branded turnkey offering to an airline-directed wholesale business model, and increasing cash burn accompanied by unprecedented leverage.

Catalyst

Ramping of American deinstalls

ARPA declining, rather than increasing, for the reasons discussed in this report

Delta multi-sourcing announcement

Continued market share shift towards ViaSat, Inmarsat, and Panasonic

SmartSky launch that pressures BA segment profitability

Continued cash burn, increasing leverage, and less-than-expected improvement in EBITDA/cash flows