Description

Company:                       SES S.A.

Security:                  Equity

Stock Price:                     €16.74/sh

Recommendation:      Long

Executive Summary/Summary Thesis

SES shares are down over 25% in the last year (from their October 2018 highs) in large part due to negative news flow surrounding the much-anticipated windfall from the C-band auction. While the stock has recovered somewhat in the last five trading sessions, I expect nearing catalysts to unlock substantial value in the company’s C-band spectrum assets and believe the risk/reward is significantly skewed to the upside, with the prospect of +50% upside (25% to 75% appreciation depending on the amount of spectrum ultimately auctioned) over the next 12 months.

While I am relatively cautious on the near-term prospects for the core business, particularly the Video segment  (I assign a 7x multiple or ~€8/sh to core – consensus is closer to €10/sh), I believe the market’s assessment of the value of the company’s C-band assets (~€9/sh or ~25c per MHz-POP midpoint depending on the auction size) is too conservative and provides a significant margin of safety. I believe the mispricing is largely driven by nervousness (known unknowns) and fatigue (no Order yet), and I view the range of outcomes as narrower than the market thinks particularly given recent commentary by senior FCC officials and anticipated bid interest.

What do we know: The Basics

Capital Structure

Company Description

SES is a Luxembourg-domiciled satellite service provider with roughly 15% market share in the global commercial Fixed Satellite Services (FSS) sector. The company owns and operates a fleet of over 50 satellites in Geostationary Earth Orbit (GEO) and 20 in Medium Earth Orbit (MEO), and primarily uses frequencies in the C-band, Ku-band and Ka-band. The main areas of satellite usage include emerging markets, where terrestrial communication is either not cost effective or not available, and transmission of media content (mainly TV programming) by distributors. Satellites allow programming to be efficiently transmitted from a single point in space to a broad coverage universe. A single GEO satellite is on a line of sight with about 40% of the earth’s surface. The signal reaches multiple antenna receivers (broadcasters, cable companies) at the same time which in turn is re-transmitted directly to end customers. Historically companies that operated in the FSS business were considered to have a ‘moat’ with long-term contracts, low customer churn, steady growth, high margins and pricing power that contributed to attractive returns of capital. In recent years, however, the industry landscape has changed with expanded capacity/coverage of terrestrial fiber networks and proliferation of high-throughput satellites which has contributed to an intensifying competitive dynamic.

SES provides services in two business units: Video and Networks.

·         Video – used for transmission of media data video from a single point to a broad coverage area. The company’s satellites cover 99% of the world’s surface and transmit video to over 350 million TV households (~1 billion people). Video transmission accounts for +60% of SES’s €2bn in annual sales. Typical contract life is 10 years and the company has over €5.3bn in contract backlog. Despite the growth in number of channels and traffic expansion from the move from digital to high-def (HD), however, the industry has experienced a structural shift to expanded terrestrial distribution in recent years which has led to pricing pressure and a sustained decline in video revenue for satellite operators. Customers like Sky are beginning to use alternative terrestrial distribution routes such as TV over IP that have lower installation costs but higher traffic expense. This has enabled some customers to approach satellite costs as a “source of efficiency”.

·         Network sales – the company provides capacity-on-demand (big data) and mobile backhaul services to government entities, telecom companies, commercial air and shipping industry operators, cruise liners, windfarm and mine operators and generally end users of technology in remote regions. Performance has improved as satellites are becoming more mainstream in the ecosystem of data networks. 

Recent Operating Performance:

Despite organic decline of -5.1% in 1H2019, below the -3.5% required to hit the low end of FY2019 guidance, SES maintained its full year guidance implying a strong rebound on 2H, particularly from the Networks business. EBITDA margins have fallen from the mid-70s to the low-60s in recent years with 2020 midpoint guidance of 62%. While I expect the performance of Video to continue to be challenged, there are reasons to believe that operations will stabilize due to strong performance of Networks on the back of new capacity.

Situation/C-Band Process

·         Background: The C-band spectrum is a set of frequencies used by certain GEO systems in the US and whose rights are owned almost entirely by Intelsat and SES. The band consists of two transmission swaths: downlink/space to earth (3.7-4.2Ghz) and uplink/earth to space (5.925-6.425GHz). The space to earth spectrum, given its desirable characteristics of broad coverage and ample bandwidth, is one of the key frequencies being targeted by 5G deployment and is now under consideration by the FCC for reallocation to terrestrial mobile. The C-band isn’t spare or lying dormant, however – it is currently being used by the satellite operators and rechanneling will involve significant friction cost.

·         News flow:

March 2019: speculation of (1) 5G nationalization, (2) congress threatening C-band sale through legislation, (3) sudden resignation of CBA’s head of advocacy and government relations.

June 2019: Chairman Ajit Pai says the FCC will act on C-band “as quickly as we can”, (2) CBA submits proposal for a C-band auction.

July 2019: Charter Communications and other groups file a contrasting proposal to CBA where spectrum migrates over to cable instead and proceeds go to the US Treasury.

September 2019: (1) Eutelsat exits from the CBA apparently due to tensions over planned allocation of proceeds and ‘voluntary contribution’ to the US Treasury, (2) FCC officials make positive comments of timing on C-band Order at a spectrum conference in Washington.

What can we infer: why is it mispriced? The key areas of debate include:

1)  Stabilization of the Core Business – prospects for improvement:

·         Ultra HD optionality – The shift from analog to digital, and then to high def TV has driven incrementally higher demand for satellite transponder capacity. The next phase is Ultra HD (UHD) which requires significantly higher transponder capacity (compared to a standard definition signal) and equates to speeds higher than many broadband connections. While significant penetration of the UHD-TV capable installed base is still a way off and content remains limited, mass adoption of a new standard could present significant upside. In France, for example, sales of 4K Ultra HD TV screens continue to rise (given the popularity of live sports) but less than a quarter of the population is covered by fiber connectivity.

·         Merger of Video and MX1 businesses – SES is pushing more of its own infrastructure and offering services in addition to capacity to customers. For example SES has made deals with the NFL and English Premier League to provide production, localization and international distribution of high value content.

2)      C-Band scenarios – dissecting the main overhangs:

·         Eutelsat: Is Eutelsat’s decision to withdraw a major impediment? I do not consider this event material given the 2-5% speculated share held by Eutelsat and FCC’s expressed view that it can move ahead with +95% but it does expose vulnerability to “hold-up” strategy by a smaller participant in the CBA. While Eutelsat’s maneuver could be a play for more economics or a louder voice, and should be resolved accordingly, the company continues to publicly support the CBA proposal and has in fact stated that it would consider rejoining. The remaining three members of the CBA hold +95% and continue to be committed to the current proposal.  

·         Fatigue: Timing of an Order? Multiple reports suggest the C-band order is slated for inclusion in the FCC meeting agenda on either October 25th or November 19th. The FCC has had several comment periods for the Order in the last 18 months and both Commissioner O’Rielly and Chairman Pai suggested or stated outright at a recent spectrum conference in Washington that they are “optimistic (they) will have results to show, on this front, this fall”. Given Eutelsat’s decision, the FCC may be incentivized to accelerate the process in order to avoid the possibility of further fallout. Even if the FCC wants to see how the T-Mobile and Sprint deal plays out over the next six months (given that T-Mobile is a potential bidder in the C-band auction), large industry participants in the wireless ecosystem have been vocal about the urgent need for more spectrum as the industry transitions to 5G.

·         Auction Structure: Which proposal? Clearly there is a lot of inbound interest in the spectrum, particularly from large mobile operators, and fixed wireless broadband providers such as Charter and Comcast, and despite high profile criticism, the FCC has been a vocal proponent of the CBA’s auction proposal as the most practical and expedient way to liberate the band. The CBA’s market-based proposal is ultimately driven by supply/demand dynamics and conforms with the FCC’s philosophical approach to auctions. Alternative plans from T-Mobile and the ACA (cable) involve allocating the proceeds differently and have generated little interest among key decision makers because it would require a much more complicated re-branding process. Ultimately the FCC may ‘cherry pick’ from the alternative plans and include a fiber component as part of the Order while substantively adopting the CBA proposal.

·         Amount of spectrum: Just 200MHz as initially contemplated or more? Since October 2018 the CBA has argued that it is only able to free up a maximum of 180MHz of C-band spectrum (200MHz total including 20MHz guard band), at least in the short-term, and any attempt to force a larger disposal would result in further delays and potentially higher clearing costs (currently estimated to be $1.5-2.0bn for 180MHz). However, recent data points suggest that progress has been made (using compression technology) towards clearing 300MHz presumably amid pressure by the FCC - Commissioner O’Rielly recently said he believes “it’s a necessity” to free 300MHz (given the political narrative in “beating the Chinese in the race to 5G”) – and wireless operators (that would like to ensure as much of that spectrum remains in the hands of the incumbents). Clearing 300MHz in the near-term would require a more involved re-banding transition and is expected to occur over the next three years in any event but assuming the auction price of the spectrum is acceptable to the incumbent satellite users, I would expect the CBA to work expeditiously to rearrange the channels, condense themselves to more limited use and free up the necessary 280MHz of spectrum (300MHz less the guard band).

·         Spectrum demand: Why is C-band so attractive? Spectrum capacity is a key strategic asset that ultimately drives market share and value for wireless carriers. C-band has already been selected by countries from Italy to South Korea as the spectrum of choice for 5G deployment given its spectral efficiency characteristics (unpaired with high frequency). C-band is considered by many to be the most important spectrum to come to market in the US since the original cellular licenses in the 1980s (which were largely allocated to Verizon and AT&T) as it could trigger the largest shift in spectrum ownership in a generation. With conservatively ~30% of US spectrum capacity (180MHz C-band of the ~700MHz industrywide) coming to market in one auction, there is a strategic imperative to accumulate as much spectrum in this band and preserve industry power. With the prospect of 280MHz coming to market instead of 180MHz, the absolute amount of capacity clearly adds significant appeal to the C-band spectrum auction.

·         Potential bidders: Will they show up? The wireless incumbents collectively have significant value at stake, both in terms of market share and enterprise value, that they need to defend, particularly Verizon. If they don’t bid and win their proportionate share of the auction, their spectrum holdings will obviously get diluted in terms of capacity. Besides Verizon, the other likely bidders, including the incumbent wireless operators, the cable operators, DISH and potential the large internet players, are generally in good financial shape – strong wireless fundamentals, healthy balance sheets and proven recurring access to the capital markets. Importantly, the dynamics for bidding tension appear to be in-place given the significant value at stake and number of potentially interested parties:

(1)    Verizon: has the highest demand for spectrum by far – they have ~15% of wireless spectrum but generate ~40% of industry wireless revenue, indicating they have been overearning on capacity by a wide margin and need to close the gap. They need the spectrum just to defend their current market position and are expected to bid aggressively. If Verizon doesn’t win a meaningful percentage of the C-band spectrum, a significant portion of their market share would be at risk.

(2)    AT&T: has ~20% of wireless spectrum and generates ~30% of wireless revenue – they are also overearning and are expected to have high demand for both tactical (to keep Verizon honest) and strategic reasons. Letting Verizon win the majority of the band would solidify Verizon’s competitive position and prove to be a very negative outcome for AT&T, T-Mobile and the cable providers.

(3)    Sprint: has significant spectrum (including its 2.5GHz holding), over 30% of capacity but generates only ~10% on industry revenue. They have been capital constrained in recent years which has led to underinvestment in their network and inefficient use of their spectrum. As such, Sprint is an unlikely bidder on a standalone basis. T-Mobile’s interest in the merger clearly stems from the untapped strategic value in Sprint’s underutilized spectrum.

(4)    T-Mobile: is in a similar situation to AT&T – they have ~15% of wireless spectrum and generate ~20% of industry revenue. T-Mobile has systematically deployed capital in their network and have been taking share. I expect T-Mobile to be an aggressive bidder, even if the deal with Sprint is approved.

(5)    Cable: the argument for the likes of Comcast and Charter bidding is twofold: (i) strategically – plant density enables them to roll out spectrum reasonably efficiently and redirect MVNO fees to their own wireless networks over time; (ii) defensively – competitive threat of 5G wireless broadband could be very disruptive.

(6)    DISH: clearly has an interest in spectrum given that it has accumulated ~15% of industry wireless capacity and presumably has a strategic need to protect it.

(7)    Large Internet Companies: it is unclear if the likes of Google, Amazon and Facebook will bid but they all have an incentive to entire the wireless ecosystem directly (given their mobile-dependent business models) and certainly have the resources to do so.

·         Spectrum valuation: indicative range? This is obviously an area of debate - while there are no directly comparable transactions in the 3.7-4.2GHz band in the US, auctions between 1995 and 2018 have generally ranged between 30c to $2.20 per MHz-POP. Outside the US, C-band auctions in Europe and Asia do provide some background for valuation including the UK (17c per MHz-POP), South Korea (19c), Australia (38c) and Italy (41c). Given the significant distortion in prices between these auctions, however, largely due to local market idiosyncrasies, it is tough to extrapolate anything meaningful to the US C-band spectrum valuation. In particular, differences in (1) bidding procedures, (2) number of participants, (3) tenure of license (15 years in Europe vs lifetime ownership in the US), (4) incumbents’ pre-existing holding of spectrum, (5) industry profitability (Wireless ARPU in the US is 3x that of Europe) and (6) regulatory landscape. I expect the aforementioned factors relating to ‘Spectrum Demand’ will have a meaningful impact on the ultimate valuation of the C-band spectrum auction, and I have handicapped the range of outcomes between 25c per MHz-POP (current market implication) and 50c, with pricing arguably surprising to the upside.

·         Government Leakage: Taxes / Voluntary Contribution? I believe the CBA will keep the majority of the proceeds but assume ~20% of gross proceeds are redirected as a voluntary contribution to the US Treasury. While it isn’t clear exactly where the negotiation will ultimately shake out, I am assuming a midpoint between CBA’s starting point of 0% a few months ago and the 40% of net proceeds the FCC received in the incentive auction.

Key Risks and Uncertainties:

·         Core business: Remain cautious on the Video segment but generally reflected in the stock at this level.

·         C-Band:

(1) Congress – Risk: Congress could take action that materially reduces the proceeds to the CBA; Mitigant: the CBA and earth station supporters could not only litigate but also make the migration process very challenging; also I would only expect Congress to really get involved if the CBA wasn’t considering a voluntary contribution to the US Treasury.

(2) Opposition – Risk: Sponsors of alternative plans could sue the FCC and disrupt the process; T-Mobile clearly has an incentive to litigate and delay the process given its pending merger with Sprint; Mitigant: the FCC has a favorable record in court and already has insight into the potential legal arguments from the comment period - any delay would probably be less than 12 months given precedent situations.

(3) Bidding specifics – Uncertainty: details such as license size, bidding mechanics and auction procedures have yet to be determined and could affect the timing/outcome.

(4) Government “take” – Uncertainty: could be different from the 20% I have assumed but generally believe it is in the 15-25% range.

(5) Sprint / T-Mobile – Uncertainty: the FCC may decide to wait for the outcome of the deal as the pro forma company will have an outsized share of spectrum, particularly in the 2.5GHz band. Also if the deal doesn’t go through, T-Mobile is potentially a significant market participant.

What is the range of outcomes? Skewed to the upside

While the range of outcomes could be vast given the list of known unknowns, I don’t recall this much value at risk and potential competitive interest in prior auctions. As such I generally believe that the risk/reward is skewed to the upside.

Valuation:

What is market currently saying?

SES is trading at ~10.3x ‘19e EBITDA of €1.24bn. Assuming the core business is worth in the 6.5x to 7.5x EBITDA range, the stock is creating the company at ~34c per MHz-POP assuming 180MGz and 22c assuming 280MHz:

My variant view:

I believe the market is discounting the lower end of the range based on transaction uncertainties and spectrum values of C-Band auctions outside the US. Given my assessment of the dynamics in the US, I believe the value framework is in the 25c to 50c context, with a skew to the higher end of the range.

Scenario 1: 180MHz cleared – was the base case, becoming lower probability

Scenario 2: 280MHz cleared – was lower probability, becoming the base case

In attempting to handicap the risk/reward, believe the main risk is execution-related (i.e. delay related to litigation etc.…) as opposed to value, so assuming further delays without much clarity on process, I would expect the stock to trade back to the ~€12-14/range or ~30% downside. In terms of upside, prices above 50c are certainly conceivable which would result in +80% appreciation. For the purposes of this analysis, I am handicapping the range between 25c and 50c, and expect a greater likelihood of 280MHz coming to market than 180MHz. As such I expect +50% upside or a €25/sh over the next 12 months.

Catalyst

This investment recommendation is all about C-band and the catalyst is the release of an FCC Order which I expect before yearend.

Catalyst

FCC Order expected before yearend.