Description

[NOTE: “Net debt” in the financial table above is an estimate using the September 30, 2016, balance sheet as a starting point.  All financial numbers will be updated in a week after the company reports its December-quarter results.]

This write-up continues my two recent themes of being the Telecom Profit of Doom and shorting stocks that we formerly owned (or vice versa).  My new target is Iridium (IRDM), which I posted as a long idea in June 2013 and we exited in June 2014.  Iridium provides voice and narrowband data communications to handsets and other mobile receptors anywhere in the world through a constellation of 66 low-earth-orbit (LEO) satellites.  For a full description of the business, which remains accurate, see my write-up from June 2013.  The stock price is currently higher than our exit price, which is amazing, because Iridium is now in deep trouble and the equity could be a zero. 

In 2014 Iridium’s prospects had already dimmed enough to cause our exit.  Since then they have worsened dramatically, thanks to repeated multi-year delays in launching its new satellite constellation, the deterioration of its balance sheet, and the strong advancement of new competitive threats.  Although the future is always especially uncertain with these kinds of stocks, I believe the stock’s most likely long-term value would be zero, apart from management’s ability to keep selling new equity to unsuspecting investors.  The company seems likely to sell new equity, which reduces the downside potential to something above zero but also caps the upside potential if the company’s profits survive the coming competitive onslaught.

To frame the discussion, here is my description of the telecom-business from previous write-ups.

My exaggerated and knowingly imprecise description of the average telecom business, from the owner’s perspective, is this:  Dig a hole in the ground, throw tens or hundreds or thousands of millions of dollars into the hole (capex), and pray.  Pray that you can earn back your capital cost before either the technology you just bought becomes obsolete or new entrants pile in and destroy the margins.  In the old days, people literally dug holes in the ground to hold the wires.  Now you might be launching the money into the sky (satellites), hanging it on towers (cellular), hiding it in corners or behind stadium seats (wifi), etc.  To put it in academic terms, telecom businesses tend to have high up-front capital requirements, high technology risk, and low barriers to entry. The big boys like VZ and T have enough structural advantages, technology diversification, government help, and cash flows such that their risks end up being fairly low.  For almost everyone else, owning the equity of a telecom business, on average, sucks. 

Satellite businesses tend to have even more risk than other telecom businesses, both to the upside and the downside.  For any given generation of satellite technology, the capex occurs in one big surge with the single-satellite launch (e.g., ViaSat-2) or fleet launch.  (In contrast, Verizon can, say, roll out fiber neighborhood-by-neighborhood at whatever pace it chooses).  The technology is locked in place after launch and can’t change for the functioning life of the satellite, usually around 15 years.  (Verizon can deploy modestly upgraded fiber equipment each step of the way).  Indeed, a satellite design must be locked down well before launch, sometimes years before launch.  The business’s ratio of fixed costs to variable costs is even higher than for other telcos, so the earnings power can swing wildly based on incremental revenue gained or lost.  On top of that, satellite companies tend to be heavily indebted.  The combination of these factors can make the stock a multi-bagger if the business gets lucky with competition but invites financial disaster if the business gets unlucky.

In 2013 we were reasonably comfortable that IRDM had a nice little niche in the satcom industry – low-latency, mobile, global coverage for voice and narrowband data – that was unlikely to face significant new competition in a time frame that mattered to the valuation.  The niche cannot be served well by geosynchronous satellites orbiting 46 times as high.  The competitive threat being discussed back then was an enormous fleet of drones or balloons.  Such fleets seemed highly impractical and therefore unlikely, were mostly talk rather than a concrete plan (they were one of Google’s internal “moonshot” projects), and were unlikely to launch for many years even if a plan advanced further.

In 2014, though, we sold our entire position when we learned of a much more feasible, much more specific, and much more threatening plan being pursued by a team within Google led by Greg Wyler, an experienced satcom businessman.  (See my exit-recommendation post #48 on the prior write-up’s comment thread, which linked to this article: https://www.wsj.com/articles/google-invests-in-satellites-to-spread-internet-access-1401666287.)  The group planned to launch a new LEO satellite constellation to provide global internet access to the underserved, at an estimated cost of $1-3 billion.  (At the time I said “let’s just call it $3 billion right now, given how these cost estimates always rise.”)  This new service would have much higher bandwidth capabilities than Iridium’s upcoming constellation.  We believed that, as demand for higher-speed data continued to grow and with voice service already reduced to just another data stream, this new venture was likely to take significant revenues away from Iridium.  Given that incremental service revenue is almost pure profit, lost revenues would decimate Iridium’s profitability.

Three years later, that project is essentially a done deal, its launch is now imminent, and its operational specifics look even worse for Iridium than did the earlier generalities.  Most of the short case against Iridium can be reduced to reading through the few pages on this web site: http://oneweb.world/

To summarize and supplement with other sources, Greg Wyler and his team, likely with Google’s blessing, left Google and started a new company called OneWeb.  OneWeb initially raised $500 million in equity funding from Airbus, Bharti (India’s premier cell phone carrier), Coca-Cola, Grupo Salinas, Hughes, Intelsat, MDA, Qualcomm, and Virgin.  Last December it announced another $1 billion in funding from Softbank and another $200 million from the initial investors, for a total of $1.7 billion invested and an equity valuation after the new round of $2.5 billion, more than double Iridium’s market capitalization.  Its board of directors includes the CEOs/chairmen of Virgin (Richard Branson), Qualcomm, Bharti, and Airbus.

OneWeb plans to launch a constellation of 648 LEO satellites, ten times as many as Iridium.  Each will have a capacity of 6 gigabits per second of broadband access to both fixed and mobile terminals – homes, businesses, vehicles, ships, and airplanes – at user speeds of up to 50 megabits per second. The satellites will be produced in a factory jointly owned by OneWeb and Airbus, which can churn out 15 satellites per week at a cost of less than $1 million each.   The data network will be 3GPP compatible and can operate with “WiFi/LTE/3G and 2G radios to provide coverage directly to cell phones, tablets and laptops.”  With these capabilities, the network can partner with traditional cell phone carriers to provide better rural cell phone coverage. 

In short, almost every facet of Iridium’s business will be under attack by an A-list-backed, better-funded competitor who has vastly superior bandwidth capacity, speeds, and network standards.  Most of Iridium's commercial voice business, which is 42% of revenues, can probably be targeted by cell phone carriers working with OneWeb or by OneWeb working with cell phone carriers.  Much of Iridium's data business is a "solution sale" rather than plain-vanilla data, but even if OneWeb itself chooses to offer only plain-vanilla broadband, other businesses can layer the solutions on top of OneWeb's bandwidth.  Only two categories of Iridium business will clearly not be under attack: (1) Services that, due to large up-front capex requirements for the required terrestrial equipment or a true lack of need for any bandwidth beyond narrowband, no one would choose to offer.  (For example, the telematics partnerships with construction-equipment OEMs like Caterpillar and Komatsu.)  (2) Government business that the Feds (mostly military) will want to keep on a quasi-proprietary network.

OneWeb plans to launch its first satellites in 2018, more throughout 2019, and begin service “as early as 2019.”  Launch dates are already contracted and scheduled with Arianespace in “the largest-ever commercial satellite launch purchase.”  The total cost is now estimated to be, of course, $3 billion.  Given how satellite timing estimates usually progress, let’s call the service start date 2020.

OneWeb is merely the first and most visible new entrant into Iridium’s niche.  SpaceX has received $1 billion in funding from Google and Fidelity to launch 4,425 satellites.  (4,425???  Is Elon Musk’s true goal to blot out the sun so that we all have to move to Mars on SpaceX ships?)  In November SpaceX filed the necessary FCC application, in which it, like OneWeb, promises gigabit-per-second speeds and a “possible” 2019 launch date.  Ten other FCC applications have been filed for LEO or MEO (medium-earth-orbit) satellite constellations.  All of these other projects, or any one of them, would merely be piling on.  OneWeb may be enough to kill Iridium all by itself; OneWeb plus SpaceX should be enough.

Meanwhile Iridium has inflicted terrible operational and financial wounds on itself, which make it much less likely to withstand new competition.  Iridium’s original constellation is already five years past the end of its originally-projected useful life of 15 years.  When Iridium re-entered the capital markets in 2008 after its bankruptcy, it predicted that NEXT would begin launches “around 2013.”  When we owned the stock in 2013-2014, that date had already been pushed to “before July 2015.”  It was then pushed again to September 2015, then April 2016, then September 2016, then December 2016, then January 2017.  Now that the first launch finally occurred in January, the delays are continuing; in a new announcement just yesterday, the second launch was pushed from April to June.  In this seventh delay announcement, management soldiers on and promises launches can still be complete by mid-2018, but late 2018 seems more likely.

With every passing month, NEXT becomes more obsolete before it ever enters orbit.  The existing constellation offers data speeds of only 128 kilobit per second, which is useless for anything other than simple machine-to-machine communication.  Despite four years of delays, NEXT will offer speeds of only 1.4 megabits per second.  OneWeb will offer speeds 35 times as fast (50mbps), and SpaceX likely will as well.  Even today, Inmarsat’s latest constellation offers speeds of up to 50mbps.  Although it uses three geosynchronous satellites rather than dozens or hundreds of LEO satellites and therefore has higher latency, Inmarsat states that it has spent 2016 developing application-specific services that target some of the same mobile markets as Iridium.

Perhaps even worse for Iridium’s equity value, the four years of launch delays have also delayed the cash flows Iridium expected to receive from the improved capabilities, and Iridium’s management has proven eternally over-optimistic about profits from the existing constellation.  Management typically provides revenue and EBITDA guidance for the current year as well as long-term guidance looking forward several years.  They have repeatedly missed their initial full-year guidance and have steadily downgraded and pushed out their long-term guidance:

·        Service revenue

o   4Q13 earnings release: “8-12% CAGR 2014-2018.”  That implied $421-489m of service revenue in 2018, with a midpoint of $455m

o   4Q14 release: lowered to “$420-465m in 2018,” midpoint $443m

o   3Q16 release: pushed out to “440-465m in 2019,” midpoint $453m.  (Using management’s original 8-12% CAGR estimate from 4Q13 and tacking on another 8-12% growth in 2019 would have yielded $455-545m, with a midpoint of $500m.)

·        “Operational EBITDA” margin (excludes stock comp and NEXT-related expenses)

o   4Q12 release: “60% in 2015”

o   2Q13 release: “55-60% in 2015”

o   4Q13 release: “60% in 2018”

o   3Q16 release: “60% in 2019”

·        Peak debt/OEBITDA leverage

o   2Q13 release: 5.0x in 2015

o   1Q14 release: 6.5x in 2015

o   4Q14 release: 6.0-6.5x in 2016

o   2Q16 release: 6.0-6.5x in 2017

·        Later leverage

o   1Q14 release: 4x in 2018

o   3Q16 release: <4x in 2019

The sliding leverage estimates are even worse than they appear on the surface.  Management originally predicted that the business could fund NEXT’s capital cost almost entirely out of operational cash flows.  But along with overestimating revenue and EBITDA, management consistently underestimated its total capex requirements.  To keep the peak leverage down to “only” 6.5x, the company has completed four separate equity offerings totaling over $300m – two of common stock and two of convertible preferred stock with an annual dividend obligation of $15m.

Iridium now faces a funding crunch.  It has over $700m of remaining obligations to Thales (the satellite builder) and SpaceX (the launcher) to get NEXT into orbit.  It had only $426m of cash as of September 30.  As of December, Iridium has fully drawn down its $1.8 billion credit facility, which, when announced in 2013, was supposed to have fully met its NEXT funding needs.  (As a reminder, Thales is French, the credit facility is a syndicated loan guaranteed by the French government export lending authority, and the French national treasury department is involved in discussions, so Iridium’s suppliers and nine creditors are coordinated.)  Management has stated that it does not have sufficient liquidity to meet upcoming payments and is in negotiations to delay some of its payments.  It publicly stated a goal of finalizing those negotiations by year-end, but unless that goal was missed as usual.  It also stated that "Iridium does not expect these modifications to include a capital raise."  Right.  Roughly 50% of management teams that are about to raise equity say they do not expect to raise equity, and this team has less credibility than most.  Given Iridium's situation, a relatively substantial equity raise during 2017 appears likely.

Even an equity raise and a delay in payments will not pull Iridium out of danger.  They would merely leave Iridium on a knife’s edge rather than in an already-existing funding deficit.  Iridium could face further launch delays, launch explosions, more satellite failures in the existing constellation, or NEXT satellite failures shortly after their launch (which are reasonably common).  Looking several years out, Iridium faces the loss of most of its revenues to the new competition.

To put some numbers on the risk, Iridium is likely to report 2016 revenues of about $437 million, of which $88 million is fixed-contract government service revenues and $20 million is related government equipment revenues.  The 2016 revenue growth rate is 6%, with most of the growth due to a contractual step-up in government service revenues from $72m in 2015.  The government payment stays at $88m in 2017 and 2018, so going forward, revenue and EBITDA will likely be flattish or up low single digits.  In rough terms, annual numbers will be:

• $450m of revenue
• $245m of cash EBITDA, including NEXT expenses and preferred dividends.  (Excluding $14m of stock comp, because this piece of the discussion is focusing on the cash levels, and management can and will keep selling stock this way.)
• $85m of interest payments
• No cash taxes until 2020
• = $160m of operating cash flow

I can’t even guess how much capex is still left on top of the >$700m owed to Thales and SpaceX.  In 2013, the post-NEXT capex forecast was $20m per year.  Management has already increased that number to $35m.  Given management's forecasting track record, I'll believe it when I see it.

Of the $450m in revenue, $350m is non-government, and most of that is vulnerable to the new competition starting in 2020.  It is plausible that Iridium loses 50% of its non-government revenue over the next six years -- which would be three years into OneWeb’s debut, possibly two years into SpaceX’s debut -- and even more after that.  (Iridium's technological obsolescence and the number of competitors will worsen over time.)  Management has always said that Iridium’s incremental margin on new revenue is around 85%.  Losing $175m of revenue would send pretax operating cash flow to near-zero and leave the business unable to fund any capex, debt repayment, or taxes.  Don’t forget taxes.  Although management has been able to guide to “no cash taxes until 2020” for many years, 2020 is not that far away now.  If operating cash flow does drop to zero, taxes will be a moot point, but if it remains positive, cash flow will take a step down.  

Two final side notes on the company’s earnings reporting.  Management has consistently omitted a share count and balance sheet from its earnings releases.  When we owned the stock, I thought this decision was an annoyance and a minor strike against management.  In light of events since then, it now looks like a huge red flag.

More importantly, Iridium is set to report 4Q earnings next week on February 23, and its 10-K should be filed the same day.  I originally intended to wait until after the release before posting so that I could incorporate the latest information.  On further reflection, flagging the short before earnings seems like good entry timing.  If the news is good – and in this context, “good news” means the absence of new bad news, i.e., they don’t miss their 2016 guidance, they don’t downgrade their long-term guidance despite the new launch delay, and their suppliers/creditors are not yet closing in – then the odds seem good that they will also announce an equity offering soon afterward, which would likely drop the stock price.  (The suppliers/creditors will likely demand another equity raise as a condition of extending payment terms.)  If the news is bad, that will also drop the stock price.  Once the earnings press release and 10-K are out with a more current balance sheet and some 2017 guidance, I will come back with the current-year EPS and EV/EBITDA multiples.  They are barely relevant given what is to come, but they will show that, even without the looming problems, the stock isn’t cheap.

Catalyst

Most important but longer term: 

• New competition in 2020 from OneWeb, SpaceX, and potentially others  
• Prior to the competitors' service launches, an increasing flow of news about the coming competition
• Possible bankruptcy

Shorter term:

• Company issues new equity with significant dilution.  (Alternatively, defaults on contractual supplier payment obligations and ultimately on the syndicated loan.)
• Guidance is missed again
• Launches are delayed again
• Long-term guidance is lowered again
• A launch explosion
• Some of the new satellites fail