Dollars And Sense: Debt Levels And Cash Flows–Analyzing Risk

By Armand Musey

Satellite companies utilize debt financing fairly extensively, although the degree varies depending on sector and company. Even though we are principally charged with analyzing potential equity investments, we recently endeavored to undertake a fairly extensive balance sheet analysis of the companies in our coverage because of increased concern about the impact excessive leverage could have on equity investors. Once completed, we made the following observations.

The companies in the satellite industry present a diverse group of capital structures that defy simple characterization. In general, overall debt levels are not problematic, although there are a few clear exceptions. However, because these companies have several different business models, it is necessary to look at both the business’ inherent leveragability and its leverage relative to its peers to evaluate underlying balance sheet risk.

Among the companies we cover, we believe the fixed satellite services (FSS) companies (except for Loral) offer the least balance sheet risk because of their relatively low debt levels and stable cash flows. In fact, some FSS companies may actually be under-levered, and shareholder returns might benefit from higher debt levels. The direct broadcast satellite (DBS) companies (except for Pegasus) also offer relatively low balance sheet risk, as their large subscriber bases should begin to generate free cash flow in 2003, allowing them to carry even more debt.

The satellite equipment companies offer varying levels of balance sheet risk. These businesses typically do not have the same potential to generate cash flow as FSS or DBS companies do, so we look for prudent debt levels and strong coverage ratios. Among the companies we cover we believe that Viasat is the least risky, with positive income and no outstanding debt. We think that if Orbital Sciences renegotiates its convertible debt, it could lower its balance sheet risk significantly and become a more attractive investment opportunity. And while we do not question Gilat’s ultimate viability, the overhang of $350 million in convertible debt mitigates almost all of its equity value.

We also cover the wireless tower operators, which like the FSS companies have a business model that is conducive to high leverage. Unlike the FSS companies, most added significant debt over the past couple of years when the outlook for 3G services and other future offerings was more favorable. We believe better-capitalized companies such as Crown Castle provide the least amount of risk.

Finally, the satellite radio companies… regardless of whether you believe this is the next greatest thing since sliced bread, these companies have developed an impressive list of financial obligations despite a lack of real revenues and an unproven business plan.

Our analysis led to a few clear conclusions. First, we have no Worldcom in our sector. Among the companies in our universe there are no large companies with excessive balance sheet risk. For the most part, over-leverage is a small company phenomenon. Typically, these companies borrowed heavily over the past couple of years to fund business expansion that has been slower to develop than originally envisioned. After taking a closer look at their balance sheets, we do not believe that any of the companies we follow is currently at risk for default. However, we do think that it will take a while for several companies to grow into their capital structures, and until they do their equity valuations are likely to remain under pressure.

Second, leveragability does not necessarily correlate with total debt levels. The business model of the FSS and Tower companies should be able to withstand the highest leverage because these are basically real-estate-like companies with long-term tenants that provide stable and predictable cash flows, which makes it relatively easy to align cash inflows with financing outflows. Although the Tower companies are highly levered, the FSS operators are conspicuously under-levered. On the other hand, the satellite radio companies have no real capacity to pay debt service, yet they have substantial amounts of debt.

Actually, debt levels often reflect management philosophy. The under-levered FSS companies have some of the most conservative management teams we have ever come across. In contrast, the over-levered Tower companies are products of financial engineering, created by management in a roll-up play to capitalize on the wireless growth. In the satellite realm, Echostar has historically carried more debt than Hughes. Echostar’s CEO is also its largest shareholder and may like debt financing because it does not dilute his interest, while GM may have kept Hughes’ leverage light to protect its own balance sheet.

This is important because leverage levels have a profound effect on underlying equity valuations, and subsequently the return on investment. Among the companies we cover, Hughes and Echostar, the FSS companies, and Orbital and Viasat offer relatively little balance sheet risk, while Pegasus, the Satellite radio companies, Gilat and the Tower companies offer relatively high balance sheet risk. We also believe it is fair to say that the companies in the latter group should trade at a relative valuation discount to those in the former group.

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.