Investment Overview and Company Description

GEOY is an obscure small cap company in an emerging market that is not yet on the radar screen of most Wall St. analysts and portfolio managers.  The company's business model and financial metrics are not well understood and the stock is only followed by one analyst at a small brokerage firm.  The sharp sell-off after its last quarterly report shows a substantial lack of investor understanding of the company and provides a compelling entry point in front of two substantial near-term catalysts.  One of these catalysts represents the single biggest risk to an investment in GeoEye but also a transformational event that should drive a substantial increase in value.  While an investment in GEOY is risky, the risk/reward ratio is substantially in an investor's favor at current prices and shares could more than double between now and the end of 2008.

GEOY provides space-based and aerial imagery and geospatial information through its satellites and imagery planes, as well as its image collection and processing ground facilities.  Its primary customer is the U.S. government, followed by foreign governments and various commercial customers.  The company currently operates two imagery satellites in orbit, OrbView-2 and IKONOS.  OrbView-2 is a low resolution satellite (providing 1.0km color resolution) and was launched in August of 1997.  It has exceeded its expected design life and is fully depreciated, although it still generates revenue providing images to commercial fisherman as well as other customers who want to monitor global environmental changes.  IKONOS is a higher resolution satellite (0.82 meter black and white, 3.2 meter color) launched in 1999 and acquired by GEOY in 2006.  It can collect about 200,000 square kms per day of imagery. It provides more detailed imagery to the U.S. government for use in defense, military planning and intelligence but also has numerous other commercial applications for oil and gas exploration, mapping, land planning and agriculture.  IKONOS was designed to last through 2007 but a recent study by the company determined the satellite could operate through 2010.

 The company is currently gearing up for the launch of its latest and greatest satellite, GeoEye-1.  GeoEye-1 will collect the highest resolution satellite imagery commercially available (0.41 meter black and white and 1.65 meter color) and will dramatically expand GeoEye's imagery collection capacity, as it will have roughly double the imagery capacity of IKONOS and over 10 times the on-board storage.  The company has a launch contract with Boeing for August 22nd, 2008 from Vandenberg Air Force Base in California.  The satellite was originally expected to launch in April 2008.  The  current launch date seems relatively firm since there is only one NASA launch in front of the company and the additional time has enabled GeoEye to complete extra functional testing of the satellite, which appears fully ready to go.  Naturally the success or failure of this launch is the biggest risk to an investment in GeoEye, and a substantial near term catalyst for the stock.  The company emerged from a bankruptcy caused by the failure of its last satellite launch in 2003, although this time around the company is carrying enough insurance to prevent bankruptcy in case of a similar failure with GeoEye-1.

Industry Overview

Until relatively recently, satellite imagery systems were the sole domain of advanced military surveillance platforms or civil space agencies.  Congress permitted U.S. companies to engage in the worldwide sales of high resolution space-based imagery beginning in 1994, and a small industry has arisen.  The most prominent players are GeoEye and Digital Globe, which recently filed for an IPO.  It is important to note that the U.S. Department of Defense has intelligence satellites operating with greater resolution than either GeoEye or Digital Globe's latest birds, however, images from these satellites are considered classified and thus cannot be used to share information with allies or even government employees without security clearances.  Therefore, there is a huge demand for space-based imagery from the U.S. government as well as foreign governments that do not have their own satellite imagery capabilities.  Other commercial applications for satellite imagery include environmental monitoring, oil and gas exploration, fishery study, precision mapping and construction planning.  One small but prominent recent application is internet-based mapping- Digital Globe provides images to Google Maps while GeoEye provides images to Microsoft.

The U.S. government is by far the largest industry customer, and purchases of inventory are done through the National Geospatial-Intelligence Agency, or NGA.  In 2003 the NGA announced it would support the development of the commercial space imagery industry by providing funding support to enable two competitors to launch next generation satellites through the NextView program.  NGA is supporting the construction of GeoEye-1 with $237M of non-recourse cost sharing, representing almost half of the $502M satellite construction cost.  The cost-sharing money from the NGA is currently accruing as deferred revenue on GeoEye's balance sheet, and will be recognized ratably after commission of the satellite.  The NextView program also includes a $197M task order for imagery (completely separate from the cost sharing) in the first 18 months of the new satellite's operation, representing about $33M in imagery orders per quarter.  Although the government has taken down some of the backlog in orders for IKONOS satellite imagery as the GeoEye-1 launch has been delayed, it would be typical for the government to “top off” the contract once GeoEye-1 has been launched.  Naturally the company expects the government to keep ordering at the same or greater level per quarter over the life of the satellite.

The NGA also funded $266M in next generation satellite construction for a launch by GeoEye's primary competitor, Digital Globe.  Digital Globe successfully launched its newest WorldView-1 satellite with comparable capabilities to GeoEye-1 in September of 2007.  DGI also filed its registration statement for an initial public offering on April 14th, 2008 and filed its first amendment on June 6th.  The prospectus is important reading for an investor in GeoEye, as it provides another perspective on the industry and shows the positive financial impact of getting an next generation satellite in orbit.  In Q4 2007, the first partial quarter of operation for Digital Globe's newest satellite, revenue jumped from $39 to $51M, and revenue increased further to $69M in Q1 of 2008.  The Digital Globe IPO represents the second substantial near term catalyst for GeoEye, as it is being led by Morgan Stanley and will come out at a substantially higher valuation than GEOY currently trades.  I expect the Digital Globe IPO to be a hot deal, as satellite imagery is an interesting emerging market and will appeal to investors as a recession-resistant business with attractive free cash flow characteristics.  GeoEye's valuation should increase as a result of having a higher-valued publicly traded comparable in the market.  Additionally, one would expect the analysts who launch coverage of Digital Globe to write on GeoEye as well, which should raise its profile among investors.

Recent Results and Situation

Despite not having its next generation satellite up in the air, GeoEye had a fairly solid 2007 as the NGA allowed it to sell IKONOS imagery under the NextView program.  The company had about $184M in revenue (55% to the U.S. government, 33% to foreign governments and 12% to commercial customers) and generated $96M in EBITDA, an impressive figure for a company with just over $400M in enterprise value.  However, it appears that 2008 will be a transitional year and the first quarter results were disappointing to investors.  The NGA has tightened up its requirement for image delivery and so orders (including both imagery and processing) have dropped from a high of $31M in Q3 2007 to $14M in Q1 2008.  Part of this was due to seasonality, as the Northern hemisphere is less amenable to imaging in the winter months, but the NGA also changed how it ordered imagery, making it more difficult for GEOY to deliver the same amount of billable imagery given the limited capacity of the IKONOS satellite.  Since Digital Globe already has its next generation satellite in operation NGA market share also substantially shifted to Digital Globe.  Naturally satellite imagery is a high fixed cost business so margins also suffered.  Q1 2008 also suffered from a number of one time charges including costs for finishing a ground station, a loss on a derivative hedging contract, a change in tax accounting and a payment related to its non-working OrbView-3 satellite.  The fact that GEOY does not give guidance or communicate with Wall St. exacerbated the problem, but gives patient investors an opportunity to purchase the shares at a huge discount to fair value.

While 2008 is set to be a transitional year and I estimate EBITDA and earnings will be substantially down, if GeoEye-1 is launched successfully GEOY's financial metrics should meaningfully accelerate in Q4 of 2008 and all of 2009.  EBITDA should fall from $96M in 2007 to around $45-$50M in 2008, but grow substantially to $130M or so in 2009 based on revenue of about $260M.  This includes $32M of deferred revenue recognition for the NextView cost sharing funds that does not represent new cash coming in.  My revenue estimate may be conservative as it assumes commercial and foreign government revenue will be flat while U.S. government revenue will rise modestly not including the deferred revenue recognition.  Most of this EBITDA should take the form of free cash flow as the satellite will be up in the air and ongoing capex should be minimal, unless development is accelerating on GeoEye-2.  

Having the additional capacity from GeoEye-1 should solve the NGA image ordering problems that are plaguing current results.  Note that in Q1 2008 the NGA ordered  $46M in pure imagery from Digital Globe while only ordering $6M from GeoEye- I expect the market share to shift back closer to 50/50 once GeoEye-1 is operational, as one would assume the government did not provide nearly equal funding for each company's new satellites if it planned on ordering 90% of its imagery from Digital Globe.  Note that the NGA's total imagery ordering was up 85% Y on Y.  GeoEye's business should only grow as they have more and better imagery to sell to foreign governments and commercial customers.  GEOY's debt also carries a heavy interest rate 13.75%, which it can refinance after the satellite has been up in the air for 18 months or so.

Valuation

Any way you slice it, GeoEye is a compelling value at current prices.  At its current EV of about $410M, it trades at 3.2x 2009's EBITDA of $130M.  Admittedly some of this EBITDA is deferred revenue recognition, but even without it the company will do nearly $100M and trades at about 4.2x on this basis.  EBITDA should grow in 2010 and beyond, and most of this should translate into free cash flow unless the company presses ahead with the launch of the GeoEye-2 satellite currently on the drawing board.

It is also helpful to think of the replacement value of GeoEye's assets.  The total cost of construction (including some capitalized interest) for GeoEye-1 is $502M, while the current EV is about $410M.  GEOY will be consuming cash for the next two quarters but taking into account additional capex to finish the satellite, government cost sharing payments and the EBITDA it will generate between now and then I think EV will be just over $500M at today's stock price at the end of Q3 2008- and this is after the satellite should be up in the air.  Satellite imaging will be an attractive duopoly industry with high barriers to entry and attractive incremental free cash flow margins, so getting the business for around the cost of the latest satellite is a bargain.  This gives no value to the IKONOS and OrbView-2 satellites which continue to produce saleable imagery despite being past their useful lives and fully depreciated.  It also gives no value to GeoEye's image production and processing business.

GEOY looks like even more of a bargain when you compare it to Digital Globe.  The initial S-1 and first amendment do not give a filing range, but even using the latest option price of $5.48 per share implies an enterprise value of over $1.4B for a very similar business, the chief difference being it already has its next generation satellite up in the air and is further along on launching its 2nd next generation satellite.  This corresponds to over 10x my estimate for this year's EBITDA, which is comparable to 2009 for GEOY as 2008 is the first full year Digital Globe will have its new satellite in operation.  Naturally I expect the final filing range to be higher than $5.48 and the value could get a substantial post-IPO pop if the deal is hot.  All of this should result in increased attention to GeoEye and upwards pressure on its valuation.

Investment Risks

The upcoming launch of GeoEye-1 is the single largest risk factor for the company, and I believe a successful launch will provide a meaningful positive catalyst.  GeoEye-1 will be put into orbit by a Boeing Launch Services Delta II rocket, which has completed 80 successful missions in a row and 129 of 131 overall since 1989.  However, the larger risk is that the satellite will not come up to full operation once it is in space.  I estimate there is a 99% chance the rocket launch will be successful putting GeoEye-1 into orbit and a 90% chance the satellite will be successfully brought up, for a joint probability of 89% that GeoEye-1 will become operational.  These estimates are hopefully conservative given that the launch delay has given GeoEye time for additional functional testing.  It's also important to note that a failed launch would not put GeoEye into bankruptcy because the company has purchased $270M of launch insurance for about 15% of the insured amount (indicating my launch probabilities are probably in the ballpark) and the government cost sharing deferred revenue liability would be eliminated.  I estimate the company would have a tangible book value of about $10.50 per share in the case of a launch failure, a reasonable guess for the downside scenario.  Of course, another launch delay represents a risk to this catalyst.

The second major risk is the NGA's ordering pattern and the NGA market share vis-a-vis Digital Globe.  The NGA has recently changed the way it ordered images from GeoEye, resulting in lower revenue than the company enjoyed per quarter in 2007.  As it has been explained to me, the NGA still has more demand for imagery than is currently being filled, but it started ordering images in a less contiguous fashion, hampering the efficiency of GeoEye's image gathering with the capacity-constrained IKONOS satellite.  Given that it has its next generation satellite in the air NGA order market share has also substantially shifted to Digital Globe.  The company believes that both of these problems will be much less relevant once GeoEye-1 imagery is available and is working with the government to resolve the issue, but there are no guarantees for how much imagery the government will purchase per quarter.  Additionally, the government is not obligated to buy images from GeoEye-1 after the initial 18 month task order, although clearly GeoEye expects the government to continue to buy imagery at the same level or higher and presumably the government would not have provided over $200M in funding to only use the satellite for 18 months.

A final risk that may hamper the attractiveness of GeoEye as an investment is a delay in Digital Globe's IPO.  While the satellite imagery business is largely insulated from a general recession due to its government-heavy customer base, Digital Globe may decide that market conditions are too poor and wait for a better opportunity to go public, which would remove one of GEOY's positive catalysts.  Hopefully the recent filing of the amended S-1 indicates the deal is on track.  Additionally, the money from going public will help Digital Globe accelerate the launch of its 2nd next generation satellite, which is slated for mid-2009.  Obviously this would give Digital Globe twice as much next generation capacity and could put pressure on pricing.

Return Potential and Payoff Matrix

I think it makes sense to think of an investment in GeoEye in terms of a probability-weighted average between a success or failure in launching GeoEye-1.  As outlined above, I think there is roughly an 11% chance the launch fails, and if so, GEOY should settle around $10.50 per share.  If the launch is successful and GeoEye's business develops as I expect, I believe it could trade at a much higher EBITDA multiple.  For these purposes I am assuming a 7x multiple, which could be conservative given it represents a substantial discount to Digital Globe's valuation.  A 7x multiple of $130M in 2009E EBITDA results in a $910M EV.  Subtract my estimate of $140M in net debt at the end of 2008 and GEOY is worth $34.50 per fully diluted share.  Probabilty-weighting these two scenarios gives me a current fair value of about $32.00 per share, almost a 90% premium to today's price.  A successful GeoEye-1 launch coupled with a oversubscribed Digital Globe IPO could result in share price over $40.