Description

HGCM offers the opportunity to capture significant value appreciation from a highly probably binary event (90% chance of successful launch), namely the launch of its Spaceway III satellite in early 2007, with limited downside of a failed launch due to the presence of launch insurance for the full value of the satellite.  The successful launch of Spaceway III and ensuing ability to dramatically reduce HGCM most significant cost – transponder capacity – could result in an 80% improvement in EBITDA, a doubling of free cash flow and an implied multiple of 4.3x EBITDA ($205mm EBITDA).  In the event of a failure of Spaceway III, HGCM will recoup approximately $300 million in cash insurance proceeds, resulting in an implied multiple of only 5.0x EBITDA ($115mm EBITDA) – offering downside protection in the event of a failure.  Provided HGCM is successful in launching Spaceway III and continues to execute its business plan, the stock has the potential to more than double.

 

HGCM is the world’s leading provider of broadband satellite network equipment and service to the very small aperture (VSAT) enterprise market and is the largest satellite Internet access provider to the North American consumer market.  HGCM has a 55% market share worldwide and over 80% in North America in the enterprise market.  HGCM serves over 300,000 consumer customers.  Enterprise churn is extremely low and consumer customers are being added at a rate of 10,000 per month.   

 

In addition, to the significant Spaceway III opportunity, HGCM has a number of other attractive attributes including: (i) continued execution of restructuring efforts following spin-off from Skyterra; (ii) NASDAQ listing expected to occur in near term (expected Sept./Oct. 2006); and (iii) subsequent analyst coverage and enhanced investor attention.  While the above summary may have enticed your interest, if limited liquidity (for the moment) is a barrier to entry for you, HGCM may not be the idea for you. 

 

Corporate History: HGCM was spun off from Skyterra communications in February 2006, following Skyterra’s decision to separate HGCM from its spectrum assets.  Skyterra acquired 50% of Hughes Communications in April 2005 from DIRECTV for $50.0 million in cash and 300,000 shares.  In January 2006, Skyterra acquired the remaining 50% of HGCM for $100mm in cash.  Apollo funded Skyterra’s acquisition and was repaid following a recent HGCM rights issue.  Both Skyterra and Hughes are controlled by Apollo Advisors who own approximately 66% of HGCM.  HGCM is currently listed on the pink sheets and applied for a NASDAQ listing around July 5, 2005.  HGCM fully meets listing requirements following the appointment of 3 independent directors in June 2006.  Assuming the NASDAQ review proceeds along a “normal” timeline, HGCM should achieve a NASDAQ listing in September/October 2006 and indications are that the Company has already attracted interest from Wall Street analysts.  The achievement of a NASDAQ listing and ensuing analyst coverage should improve liquidity.

 

HGCM has recently undergone a significant restructuring transforming the Spaceway business model from one, initially devised while under DTV management, on developing a satellite broadband alternative with coverage across the US to one focused on providing a broadband alternative to those rural customers lacking access to a viable terrestrial alternative.  This strategic decision and subsequent restructuring dramatically transformed the company and led to aggregate cost cuts of approximately $75 mm in 2004/2005.  HGCM’s cost cuts have produced results and according to the company are expected to continue to  yield results in 2H 2006 – “The aggressive cost reduction initiative from last year are producing good results and we expect this trend to continue in the next two quarters.” (2Q press release)

 

Spaceway III Opportunity:  Spaceway III represents the most significant element of the Company’s business plan and can easily be considered transformative.  Following the launch of Spaceway III, HGCM will be in position to significantly reduce its most significant cost factor – satellite transponder capacity and improve EBITDA by at least $90 million over the ensuing few years.  HGCM currently leases Ku band capacity from a variety of fixed satellite service providers (Intelsat, SES Global etc.).  Spaceway III will allow HGCM to replace approximately 90 transponders of satellite transponder capacity at an average cost of $1-1.5 mm per transponder.  HGCM plans to add new and renewing customers to Spaceway III.  The vast majority of capex on the satellite has been completed and paid for and launch is currently targeted for early 2007.

 

Business Model: HGCM operates in 3 business segments. 

·         Enterprise VSAT essentially provides large enterprises with high-quality broadband connectivity across every site, regardless of location, allowing customers the ability to aggregate store-level data and other 2-way data communication capabilities (such as e-learning).  Enterprise VSAT networks are critical to the effective management of any large multi-store enterprise. Enterprise, which is a major factor driving HGCM’s extremely high renewal rate.   VSAT comprises approximately 61% of total revenue.  Customers generally enter into contracts of 3-5 years.  HGCM generates revenues through hardware sales for each site and service fees for managing the network.  Approximately half of HGCM’s revenues in this segment are generated from equipment sales.  Customers include retailers, such as Walmart, oil companies, such as Exxon, restaurants, such as McDonalds and many others.

·         Consumer broadband (31% of revenue) consists of subscribers in North America who desire high-speed Internet access, but typically are not served by either DSL or cable.  The North American consumer market is estimated to amount to 10-15 million households and 3 million businesses.  The vast majority of HGCM customers currently lack a terrestrial alternative.  HGCM currently adds 10,000 customers per month and has consistently done so, since the launch of the service a few years ago.  Churn is approximately 2% and ARPU is $60 per month.  The company has over 300,000 subscribers in this segment.

·         Telecom Systems consist primarily of mobile satellite systems (6% of revenues) and supplies turnkey networking and terminal systems to these operators.  Customers include Inmarsat and Thuraya communications.  Mobile satellite systems is profitable and has displayed recent growth from a number of customer wins and new product introductions.

 

Valuation: HGCM has an enterprise value of approximately $880 million and a 2006E EBITDA of $115-120 million, implying a multiple of approximately 7.5x.  Its two closest comps (though far from perfect) are Gilat Satellite networks (GILT) and Viasat (VSAT).  GILT and VSAT trade at approximately 7.0x and 13.0x, respectively.  Gilat offers enterprise-based VSAT similar to HGCM’s enterprise business with a bend toward the international side (given HGCM’s dominance of the US market).  Gilat lacks the upside (albeit coming off a restructuring of its own) offered by HGCM’s consumer business and already completed restructuring.  Viasat is primarily a manufacturer of VSAT hardware and other satellite communication device for military uses.  The operation and management of VSAT networks is not a significant portion of its business.  Viasat provides VSAT terminals for Wildblue customers.  HGCM’s current valuation does not appear to take into account the growth in its consumer business and significant margin expansion from the Spaceway III launch, as well as its strong competitive positions. 

 

On a free cash flow basis, HGCM generates approximately $1.70 per share (normalized for taxes) of pre-launch free cash flow and has a $135mm NOL (PV of $100-110mm) or about $5.50 per share, implying a normalized free cash flow multiple of 10x (ex. Bemefit of insurance proceeds).  On a post-launch basis, normalized free cash flow could more than double to approximately $5.00 per share, implying a normalized free cash flow multiple of about 5.3x.

 

Assuming, a successful launch of Spaceway III, HGCM could generate $205 mm of EBITDA on a normalized basis.  Capitalizing this EBITDA at a conservative 7.5x multiple, implies a share price of approximately $67 per share. 

 

Risks: There are three primary risks.  First, enterprise VSAT market share declines and margin compression accelerates in the face of competing technologies.  Without discounting this potential threat, few of the competing technologies are new and HGCM has maintained its market share and margins over the past few years through (i) limitations on other technologies in providing a true, 2-way point-to-multi-point offering; (ii) existing contracts which have not rolled-off; and (iii) repositioning of HGCM’s offering to include managed service offering to include both satellite and land-based alternative.  Management has indicated that it does face margin competition, but to date it has offset significant declines by combining its satellite product in conjunction with terrestrial alternatives (a combination few, if any, providers can match). 

 

Second, HGCM’s consumer build-out could face intensified competition from either Wildblue or terrestrial alternatives (if they ever become available).  Wildblue offers a similar service to HGCM via a wholesale model versus HGCM’s retail model.  While Wildblue has launched and operates 1 satellite (thereby saving on transponder costs), it markets its products through a variety of channels such as AT&T and more recently DirectTV, paying commissions to each of these providers.  Wildblue acquires its terminals/equipment from Viasat (VSAT).  Like HGCM, Wildblue adds approximately 10,000 customers per month, but only has a current base of under 50,000 customers (best-guess estimate).  Given that HGCM, only achieved breakeven profitability at 200,000 customers, Wildblue likely is not profitable.

 

Finally, the potential exists that Spaceway III could fail at launch or post-launch.  The probability of failure at launch is 10% and less than 1% post-launch.  While the failure of Spaceway III would delay the achievement of the near term EBITDA improvement, such failure would not be fatal.  Spaceway III will be insured for its full book value (approximately $300mm) and HGCM will continue to maintain its existing business, which generates approximately $115mm of EBITDA.  If one assumes a failure of Spaceway III, you would still own HGCM at an EBITDA multiple of only about 5.0x.  The excess cash could be used to (i) repay debt; (ii) build a new satellite (2.5-3 year timetable); (iii) purchase other in-flight satellites owned by DTV (HGCM has a right of first refusal to acquire Spaceway I and II from DTV as part of its 2005/2006 acquisition); (iv) acquire other VSAT operators to further enhance scale and cut costs.

Catalyst

• NASDAQ listing (expected September/October 2006)
• Subsequent analyst coverage
• Continued strong results with less confusing financials following significant 2004/2005 restructuring
• Spaceway III launch and subsequent margin improvement through decline in satellite capacity costs (approximate 80% improvement in EBITDA)
• Acquisitions of complementary businesses (high fixed cost business with room for significant cost synergies)