Dollars And Sense: Fixed Satellite Services: Is It Time To Take Another Look?
by Armand Musey
It is time for investors to revisit the Fixed Satellite Services (FSS) industry. We realize that satellite and telecom infrastructure plays are currently far from vogue. However, FSS is a $7 billion global industry with high barriers to entry that throughout the next several years should experience stable, albeit moderate, revenue growth, has very high EBITDA margins, and generates strong cash flow even in a negative economic environment. No doubt, the industry is working its way through a bout of overcapacity, but this is being met by solid demand growth from new video and data applications, and we expect the larger operators to benefit even further from consolidation and expansion into value-added services. Given the depressed levels at which all of these companies are currently trading, we believe the best of them represent good investments.
We view the FSS industry essentially as a defensive telecom play. The FSS business model is similar to the real estate business. The key drivers for returns in the FSS industry are capacity pricing (rents) and utilization (vacancy rates). Like landlords, FSS operators build and launch satellites, then they lease the capacity on these satellites to various telecom and video customers. Typically it costs about $225 million to build and launch a satellite, and takes about three to four years to fully lease its capacity. The leases are often long-term, sometimes covering the entire expected satellite life of 12 to 15 years, and generally involve large, high-credit, quality customers. As with real estate, the better credit a customer has, the more capacity they take and the longer the agreement, the lower the per-unit price. Once fully leased, a satellite can generate EBITDA margins above 80 percent.
We project the FSS industry will generate a 6.5 percent revenue CAGR throughout the next five years. We expect growth to be driven by new video and data applications, particularly point-to-multipoint applications, where satellites have an inherent advantage as costs are independent of the number of recipients, so long as they are all under the arch of the satellite broadcasting the signal. In particular, we look for strong growth in demand for FSS capacity from television programmers as they expand their programming offering to fill the demand for incremental channels from recently upgraded digital cable systems and begin to roll-out HDTV formatted programming. We also look for strong demand from VSAT and other enterprise network operators who can deliver secure and redundant private corporate networks via satellite.
With an underpinning of solid demand, we expect further consolidation of the FSS industry to drive improved economic returns, particularly for the larger operators, at a cost to some of the smaller players. This is because, even though industry operating costs are generally less than 30 percent of revenue, most of this is fixed so there is significant synergies to be had from consolidation due to the potential for economies of scale. This should enable the larger operators to generate EBITDA growth faster than overall industry revenue growth, while being more effectively able to manage excess capacity. Consolidation is already underway, evident in last year’s purchase of GE Americom by SES. We believe that once the former IGOs complete their IPOs, a further round of consolidation is likely.
We also expect the larger and more commercially savvy FSS operators to expand down the value chain by introducing enhanced value-added services, such as Panamsat’s Spotbytes service, or those offered by Loral’s data service segment. These services not only allow the FSS providers the opportunity to utilize unused capacity. But, because of their value- added nature from the customer’s perspective, FSS operators can often charge premium prices for these incremental services, thus generating significant upside versus the alternative of dumping unused capacity onto the spot market. Value-added services under development include uplink services, VSAT support, teleport, data caching and perhaps ultimately integrated offerings in conjunction with fiber companies, just to name a few.
Given the FSS industry’s positive growth prospects and relatively low risk profile, the FSS stocks appear very attractive at current valuation levels. At the end of October, the stocks of the larger FSS companies were trading at near 10x 2001 estimated EBITDA, which is unwarranted given our assessment of their prospects. We suspect that investors have somewhat indiscriminately rolled up these stocks with other telecom issues and dismissed them generically. We believe that investors who have done this, do so at the risk of missing the boat. We would watch for these stocks to appreciate in the coming months as investors realize the stable nature of the industry and its growth prospects, and would look to the larger companies to be the biggest beneficiaries of most of the major industry trends.
Armand Musey is the satellite communications analyst at Salomon Smith Barney (SSB). The foregoing article should not be considered as a recommendation with respect to any security. SSB and its affiliates may maintain a long or short position in, act as a market maker for, or purchase or sell a position in, securities of referenced entities and may also perform investment banking, advisory, or other services for any such entity.