GeoEye (GEOY) Analysis

I’ve been looking into a company by the name of GeoEye after reading up on a very detailed and well written analysis by Chris Fernandez of Peak Stocks. If you are interested in small caps and don’t believe stock price volatility is a correlated indicator of business performance, then you should consider reading more of his work by going here (broken link).

Before you read on, keep in mind that I am in the initial phases of poking around and nothing should be taken as granted. However, I plan to complete my research by August 22. Continue on to find out why.

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Business Summary

GeoEye is a provider of high resolution and low resolution global space-based and aerial imagery and geospatial information through their processing and distribution network to customers around the world.

For many people, that sentence is probably a headache but it can be summed up with the following image below.

You may have seen this type of image somewhere… like Google Maps. Google is one of the latest customers making use of GeoEye’s high resolution imagery.

GeoEye achieves these images through its two satellites, the IKONOS high resolution and Orbview-2 low resolution satellite. They then sell and also have distributors that resell these images to local and worldwide customers for various applications which are listed below.

Growth Strategy

On August 22, 2008 GeoEye will be launching their latest satellite, GeoEye-1. GeoEye-1 is their new polar-orbiting, sub half-meter Earth-imaging satellite. In simple terms, GeoEye-1’s orbiting path is perpendicular to the equator and will travel at a velocity of around 7.5km/sec or 16,800mi/hr 700-800km above the earth and is capable of taking images of objects smaller than a 1m/3.3ft. The satellite is capable of revisiting any point on the earth roughly every 3 days.

With the launch of GeoEye-1, the images collected will have a ground resolution of 0.41m/16in in black and white while color images will be collected at 1.65m/65in resolution. But due to US Government requirements, the images have to be re-sampled to a minimum of 0.5m/20in for all customers.

GeoEye-1 will offer better resolution, accuracy (to within 3m/9ft), agility and capacity (on board memory is 1TB) compared to IKONOS. Already there is quite a large order backlog in anticipation of the GeoEye launch with international customers making up a large sum of the revenue for GeoEye.

Applications in which the images from the satellites can be used are as follows:

Defense
National and Homeland Security

Air and Marine Transportation
Oil and Gas
Energy

Mining
Mapping and Location-based Services
State and Local Government

Insurance and Risk Management
Agriculture
Natural Resources and Environmental Monitoring

Just look at the vast and diverse range of applications which GeoEye could service.

Competitive Position

GeoEye’s only US competitor is DigitalGlobe for satellite remote sensing. This is where customers can directly access the satellite for real time downloading when the satellite is within their range. You can think of it like a web host. You don’t own the servers but yearly fees provide you with access to it. But why only one competitor?

Consider the following;

Niche market
These satellites take about 4 years of research, funding, tests and approvals before being launched
Requires a synced network of ground operations and processing facilities

Highly regulated business which requires licenses from the Department of Commerce (“DoC”) and from the Federal Communications Commission (“FCC”)
Remote sensing technology is subject to U.S. export control licensing and regulation
To operate internationally, “remote imaging satellites may require International Telecommunications Union (“ITU”) coordination and registration and licenses from the governments of foreign countries in which imagery will be directly down linked.”

This all spells Big moat.

However, in the aerial imaging side of business, there are many smaller and private companies that offer aerial photography due to the low barriers of entry. But these companies are limited in their coverage and operate locally. Due to the high levels of competition in this area, margins are low.

Getting back to DigitalGlobe. DigitalGlobe is believed to offer the current highest level of resolution with its WorldView-1 satellite launched in September 2007. Unlike GeoEye-1, DigitalGlobe can not take color images.

Their next satellite, WorldView-2 is anticipated to launch in late 2008 as well as the company planning to go public.

Risks

For those that had the interest to make it thus far, this is a very high risk/reward company.

Here are some risk factors that I came up with pretty quickly.

GeoEye-1’s planned launch was the first quarter of 2007 but due to program delays the launch was rescheduled for April 16, 2008. However, competition and higher priorities for the use of the launch pad during April was too great and GeoEye-1 was again scheduled for August 22, 2008. There is a possibility that the launch may be delayed again or even fail.

The launch may be successful but GeoEye-1 could be inoperable once in orbit.

The Government which accounts for 55% of GeoEye’s revenue may decide to build their own systems which would reduce GeoEye’s business.

Currently as it stands, the biggest risk would be a launch failure of GeoEye-1. Should this happen, there is no doubt the stock price will plummet vertically. Yet it also has such a high reward factor because the delayed launches have punished the stock from 35 to the low 20’s.

Financials and Valuation

Let’s start with something from Peak Stocks which is dead on. Even an investor on the last conference call was lashing out (very amusing) at management because the company was selling for less than book value.

“In order to build and launch GeoEye’s next generation satellite, GeoEye-1, GeoEye spent about $250 million and was reimbursed for another $250 million from the National Geospatial-Intelligence Agency’s (NGA) NextView program.

All told, it took about 4 years to build and design the satellite, with an expected launch date of August 22nd, 2008.

When you include the costs to build the satellite, test it, launch it and get insurance on it, the total runs at around $500 million.

At today’s market cap, GeoEye is trading for LESS than the actual value of this satellite alone!

Even if someone came today, and decided to buy out GeoEye and offer them $500 million (a premium of about 66% at today’s closing price), they would essentially be getting the rest of GeoEye’s assets for FREE!

That includes: Their offices and employees, ground stations, current contracts and backlog totaling over $250 million, 2 operating satellites (OrbView-2 and IKONOS), and all other current assets such as their MJ Harden acquisition, joint ventures, etc.” – peakstocks.com

It’s clear that the company is cheap but there are some things to watch for. Although the GeoEye-1 project is fully funded, long term debt is on the high side, by my standards, and cash flows are very erratic and inconsistent. So in addition to the risks stated above, I can’t say for sure how this company will continue to perform many years down the track. But once GeoEye-1 is up, it will certainly give a better indication of the revenue stream to be expected.

Another point to consider about revenues is that GeoEye does not sell “images” like photographs or paintings. Instead, they have contracts for a number of years whereby allowing customers to have access to the satellite. This means that they are paid for the service whether the customer uses it or not.

This is a good business model and is evident in their ever increasing margins. Fiscal 2007 shows gross margins of 58.3% compared to 45.2% in 2006. SG&A margins have decreased from 30% in 2005 to 16% in 2006 and 2007. Operating and net income margins for 2007 were 42% and 23% respectively while it was 28.6% and 15.5% respectively the prior year.

If you look at the type of business GeoEye is in, the way income is generated and take it in context, GeoEye-1 will have a BIG impact on both the top and bottom line.

Taking a quick look with the DCF and Graham valuation software where my growth input for FCF and earnings is extremely pessimistic and close to no growth, I still get a value showing that GeoEye is trading for a price where you are getting the GeoEye-1 for free.

One thing is clear. The company is cheap. Not due to failing business fundamentals or economic factors, but due to uncertainty which Wall Street hates.

Management

Some quick notes on management.

They don’t offer guidance and make it clear that they don’t intend to. This is good because it shows that they are concentrating on the business and not on keeping Wall Street and the single analyst following the company happy.
They put their money where their mouth is. Unlike my disappointment with AeroGrow.
Interests aligned with shareholders.

Read and listen to a conversation between Chris Fernandez and with GeoEye’s CEO and CFO on his post (broken link).

Opinion

Here is a compelling risk/reward company where the risk lies mostly on uncertainties which are not related to business practices and fundamentals.

For those with a long term horizon and can weather small cap volatility, this could be an interesting addition to your portfolio. Just remember, expect your investment to be cut in half if the launch fails. Having said that, I am beginning to see that the upside outweighs the downside.

In the meantime there are still many things I have to go through before August 22.

Disclosure

No position in GEOY