Description

We believe that Intelsat is an incredibly attractive investment with the potential to double or triple (or more) within the next two years.  Intelsat is the largest satellite operator in the world, and since its IPO in April 2013, the stock has languished due to uninspiring operating performance.  Investors have largely cast Intelsat aside just as the company should see tremendous growth in its free cash flow due to (1) new satellite launches, (2) stabilization in its weak African and government businesses, a (3) a largely fixed tax expense and (4) significant debt paydown.   We believe this inflection in operating results can generate significant earnings growth and also lead to improved investor sentiment which should yield massive upside for the equity, given the company’s financial leverage (7.5x EBITDA).  With earnings potential of $4 to $5 per share over the next couple of years (growing to $6+ thereafter), even at a modest multiple, a stock price of $40, $50 or even higher seems likely versus the current level of $15.48.

We will walk through the following key tenets of the thesis in detail below:

·         This is a highly predictable, highly defensible and highly profitable business

·         Underlying operating performance is stabilizing and the risk of further material downside is low

·         Operating profit is poised to resume growing due to recent and upcoming satellite launches

·         The company has a very attractive and underappreciated tax structure

·         The company’s debt load is very manageable and the credit markets agree

·         The stock is not well-covered and has diverged from its peers

·         The path to $4 to $5 of earnings and a $40-50 stock is reasonable and credible

Highly Predictable, Highly Defensible and Highly Profitable 

Intelsat owns and operates a fleet of more than 50 satellites, providing fixed satellite services (FSS) globally.  Intelsat’s business is both highly visible and highly profitable.  Customers generally enter into multi-year, non-cancellable contracts and Intelsat’s $10.1 billion backlog represents 4x this year’s revenue of $2.5 billion.  Each year, approximately 90% of revenues come from the backlog and contract renewals.  EBITDA margins have been consistently above 75% and incremental margins are nearly 90%.

Intelsat’s primary business consists of leasing satellite capacity to media, enterprise and government customers for the transmission of data.  The positioning and reach of the satellites allows for a more cost effective distribution of data to multiple points at once (such as cable headends) as well as hard to reach places (such as offshore rigs and mines) than other forms of data distribution like fiber.  The satellites also serve as backhaul for wireless services in emerging markets lacking sufficient fiber infrastructure and in maritime and aeronautical applications, which are growing nicely.  Intelsat’s “real estate” is incredibly valuable and nearly impossible to replicate as the industry is highly regulated with a limited number of available orbital slots to fly satellites.  Intelsat does not pay rents on its orbital slots and as long as there is functional capacity at a given slot, Intelsat effectively owns the slot in perpetuity.  Once launched, the satellites have a useful life of ~17 years, but recent technological advancements have extended the useful life of some satellites to nearly 30 years.  The satellites are depreciated over a 17 year useful life and depreciation is a good proxy for average annual capex.  Pre-tax returns on assets and tangible invested capital have consistently been 20% and 30%, respectively, over the last several years.  Aside from Intelsat, the other large publicly listed providers of FSS are SES (SESG FP), Eutelsat (ETL FP) and Inmarsat (ISAT LN).        

Moving Past Recent Customer Headwinds

The recent weakness in Intelsat’s operating performance has been focused in Africa and the company’s government business.  We will address each below.

Africa has recently been plagued by pockets of oversupply.  Oversupply of capacity is not a new issue in the FSS business and it has afflicted nearly every region at some point in time until demand for data and communications services catches up.  Intelsat currently generates 15% of its revenues from Africa and the Middle East, but a significant portion of that comes from long-term contracts with media customers which are locked-in and not experiencing pricing pressures.  Roughly 7% of total revenues have been affected by these supply issues.  The good news is that the bulk of this business has been re-priced and is reflected in the most recent quarter’s results.  Longer term demand for media services in Africa is solid as evidenced by Intelsat’s recently announced 15-year contract with Multichoice, a provider of satellite TV services in Africa.  Under this contract, Intelsat will order a new satellite and leverage one of its orbital slots to provide long-term service to Multichoice customers.  While this satellite won’t be launched until 2016, this revenue is all incremental.

Intelsat’s government business is roughly 15% of total revenues, but, importantly, only about half of that is high margin “on-net” business (meaning leased capacity on Intelsat-owned satellites).  The government business is down roughly 15% this year due to pressures from the lingering effects of sequestration and troop reductions in Afghanistan and Iraq.  Revenues in the government business are run-rating at levels 25% below their peak in 2012 and are close to 2008 levels, a period when demand for UAVs (drones) was substantially lower than where it is today.  While the US government has been able to shift some capacity to some of its previously commissioned satellite constellations, there are no new satellite programs in development by the Department of Defense.  However, demand for UAVs as well as increasing demand for communications and data services by the military should support a return to revenue growth in Intelsat’s government business over the next several years.         

References on growing government needs for commercial satellite capacity:

1.       http://www.nationaldefensemagazine.org/archive/2013/April/Pages/SatelliteShortagesMayChokeOffMilitaryDroneExpansion.aspx

2.       http://www.defenseone.com/technology/2013/09/why-military-needs-commercial-satellite-technology/70836/

Satellite Launch Schedule Points to a Positive Inflection in the Business

New satellite launches offer an opportunity to refresh and increase capacity and drive revenue growth through higher prices and newer services.  However, before October of this year, Intelsat hadn’t successfully launched a satellite since the middle of 2012 as an early 2013 launch was unsuccessful due to a rocket failure shortly after liftoff (the company’s first launch failure since 1996 – a streak spanning an industry-record 39 consecutive successful launches).  As a result, Intelsat’s capacity has been flat for the last two years and they have not had opportunities to capitalize on the stronger parts of their business, which has amplified the weakness in Intelsat’s African and government businesses on reported results.  This will be resolved as a recent successful launch comes online and future scheduled launches drive the business in 2015 and beyond.

In October, Intelsat successfully launched its first satellite in more than two years.  IS-30 serves DirectTV customers in Latin America and is sold out for the duration of its mission.  Revenues from this satellite (~$50 million per year) are all incremental.  In 2015, Intelsat is launching three more satellites:

·         IS-31 is the in-orbit backup satellite to IS-30 and is also sold out for the duration of its mission.  Revenues from this satellite (~$30 million per year) are all incremental.

·         IS-34 has sold out most of its capacity and the revenues from this satellite represent a combination of transitional customers and incremental business.

·         IS-29 is the first of Intelsat’s EPIC satellites.  The EPIC satellites represent Intelsat’s foray into High Throughput Satellites (HTS).  The EPIC platform is focused on data and enterprise services, including mobile backhaul in the less fibered parts of the world.  Intelsat has booked $50 million of annual revenue for the first 10 years of service of this satellite and most of that is incremental to Intelsat.  This satellite can ultimately generate annual revenues of $200 million and the cadence of pre-sales should improve as we get closer to launch.

With the exception of IS-30, which will contribute a full year’s worth of revenue in 2015, these satellite launches will contribute little to reported results in 2015.  The 2015 launches are scheduled for the back half of the year and it can take a couple months until a satellite completes in-orbit testing and is revenue-generating.  By 2016, Intelsat’s results should reflect the full impact of these satellite launches and revenue growth will inflect positively.  Intelsat also has four more launches scheduled over the course of 2016 and 2017.  We should note that these launches are insured and Intelsat received $406 million of proceeds following the launch failure of IS-27 in 2013.

The Tax Structure is Attractive and Underappreciated

Intelsat is domiciled in Luxembourg and has negotiated a fixed tax expense with the government of between $60 and $70 million per year.  Since Intelsat’s tax expense is not dependent on the profitability of the business, the benefits of EBITDA growth and reduced interest expense over the next several years will accrue entirely to shareholders. 

While Luxembourg has been in the news lately for helping multinationals reduce their tax bills in places like the United Kingdom, this is an entirely different situation.  Intelsat is incorporated and headquartered in Luxembourg and its income producing assets are in space.

Furthermore, SES and Eutelsat do not have nearly as attractive a tax structure and, as a result, comparing the companies based on EBITDA multiples is highly misleading, which we will address in more detail below.

The Debt Load is Manageable and the Credit Market Agrees 

Intelsat has $14.6 billion of net debt ($11.6 billion of high yield and $3 billion of secured term loans) which equates to 7.5x of leverage on $1.9 billion of EBITDA.   With a market cap of under $2 billion, Intelsat’s equity as a percentage of enterprise value is just 11%.  Given the small equity component, one might casually assume that the debt is distressed, but interestingly, nearly all of Intelsat’s bonds trade at par or better and the bond trading at the largest discount to par is a 5.5% bond due in 2023 which was last quoted at 95 and yields less than 6.5% to maturity.  Intelsat is one of the largest and most liquid issuers of high-yield debt in the market and they have been issuing paper since the early 1990s. 

We believe that debt investors have a well-informed and reasonable view that a business with stable, long-term contractual revenues and nearly 80% EBITDA margins is capable of servicing this level of debt.  Intelsat has no maturities until 2018 (~65% matures in 2020 or later) and is devoting all of its excess free cash flow to debt paydown.  Despite the optically high leverage multiple, Intelsat’s high EBITDA margins and low, fixed tax expense allow Intelsat to earn adjusted net income margins of more than 15%, providing equity holders with predictability of cash flows similar to many large, profitable and unlevered companies. 

We are intrigued by the large disconnect between the debt and equity markets’ view of Intelsat.  While the debt currently yields 8% or better on 90% of the capital structure, we think it is remarkable that equity investors are being offered an earnings yield above 20% for the remaining portion.

The Stock is not Well-Covered and has Diverged from its Peers

We think some of the pricing disconnect between the debt and equity markets boils down to limited liquidity, the lack of a natural shareholder base and poor research coverage. 

While Intelsat is the largest FSS company in the world by EBITDA, it had never been a public company prior to last year.  Intelsat began as an intergovernmental organization in the 1960s and was privatized in 2001.  In 2005, a consortium, consisting of Apax, Apollo, Madison Dearborn and Permira, acquired Intelsat, which ultimately sold it to BC Partners and Silver Lake in 2008.  BC and Silver Lake did not sell any shares in the IPO and have not reduced their position subsequent to the lock up expiration last year.  Together, the sponsors own more than 70% of the shares outstanding.  The stock trades between $5 and $10 million per day, making it difficult for large institutions to build a meaningful position.

Intelsat’s closest comps are SES and Eutelsat, which are both listed in France and naturally have a European heavy investor base.  They both trade at premium market valuations due to the quality of the FSS business (19x and 17x 2015 EPS, respectively) and are up 23% and 15% YTD, respectively, versus Intelsat’s decline of more than 30%.  In addition to geography, Intelsat’s divergence from its peers may have something to do with the sell-side analyst coverage.  Of the 10 analysts listed on Bloomberg covering Intelsat, only two of them also cover SES and Eutelsat.  The other analysts are US-based cable and telecom analysts that don’t follow the industry.  The stock appears to barely be on anyone’s radar screen in the US.

Getting to $4 and then $5 of EPS and a $40 to $50+ Stock

Our projected increase in Intelsat’s EPS is primarily driven by increased EBITDA from the aforementioned satellite launches and lower interest expense from debt paydown and refinancings.  Below we provide a bridge from Q3 actual results to our estimates for 2015 and 2016.

In Q3 of this year, Intelsat recorded EBITDA of $485 million and Cash EPS of $0.79.  We focus on Cash EPS instead of FCF as capex can be lumpy depending on the launch cycle and depreciation is a good proxy for annual average capex.  Annualizing these numbers implies run-rate EBITDA of $1.94 billion and Cash EPS of $3.14 and is a good starting point when thinking about 2015.

The above bridge gives Intelsat no benefit from the 2015 launches and assumes no recovery in the government business and builds in an additional $10 million of cushion.  The run-off revenues are related to certain legacy contracts which have been in run-off for a number of years and are a headwind that should largely abate by 2017.  Bad debt has actually benefited EBITDA in 2014, but we expect this expense will normalize in 2015.

Net income will be boosted by at least $40 million from interest expense savings after calling the $500 million 8.5% notes this past October.  We don’t contemplate any incremental debt paydown in 2015 in the table above, which is conservative.  Net income will benefit from more interest being capitalized into capex in 2015.  Intelsat’s capex guidance includes capitalized interest and next year’s heavier launch cycle means higher capex and higher capitalized interest.  This is not double counting or an accounting trick as depreciation includes the amortization of interest expense previously capitalized.  We are also anticipating higher depreciation and slightly higher taxes as Intelsat’s current tax expense remains low (estimated to be $30 million in 2014) due to some tax assets (it will be several years before Intelsat’s tax expense ramps up to the $60-$70 million level).

By 2016, we expect the cumulative effects of the 2015 satellite launches will drive EBITDA back up to nearly $2 billion and incremental debt paydown as well as the expiration of $1.6 billion in interest rate swaps in January 2016 will drive Cash EPS to $4.

By 2017, we anticipate that additional satellite launches and increased sales on the first EPIC launch (our 2016 estimates anticipate modest additional sales beyond what’s currently been sold) will increase EBITDA by an additional $85 million.  Combined with further deleveraging and refinancing actions, we expect adjusted net income will top $580 million, or nearly $5.00 per share.

Based on our projections and street estimates for SES and Eutelsat, Intelsat trades at a significant discount on a levered basis and a modest discount on an unlevered basis.  

However, as we alluded to above, EV/EBITDA is a poor metric of comparison here due to the different tax structures.  While SES is also incorporated in Luxembourg, they have negotiated a low-teens tax rate vs. Intelsat’s fixed tax expense.  Eutelsat is domiciled in France and pays a tax rate of 38%.  As a result, we believe that EV/NOPAT is the appropriate metric for unlevered comparison.  When we re-run the table above, but use EV/NOPAT, we see that Intelsat trades at a meaningful discount on both a levered and unlevered basis:

As Intelsat launches satellites next year and anniversaries declines in its African and government businesses, the top line will be flattish to slightly down in 2015, but should grow in the low to mid-single digits in 2016.  Once that growth becomes apparent and is understood by investors, we expect the perception of the stock and story will positively inflect and believe that Intelsat, in our base case scenario, can trade at 10x earnings.  This would imply a share price of $40 in about a year, 150% above current levels.

However, if Intelsat can narrow the EV/NOPAT discount with peers to a still pretty wide 20%, then shares could be worth nearly $50, more than 200% above current levels, over the next 12-15 months:

Catalyst

- Successful satellite launches

- Inflection in revenue growth

- Continued debt paydown and refinancings

- EPIC bookings