Wednesday, August 27, 2008 Activist Investor: GeoEye's Seeing Things My Way

08/25/08 - 02:22 PM EDT
By Eric Jackson

My first Activist Investor column for in March featured GeoEye (GEOY - Cramer's Take - Stockpickr), a satellite company in which I had just started an activist campaign.

This investment is down more than 20% since the start of the year (despite a 50% run-up since mid-July); however, the company's management has been receptive to recent behind-the-scenes activist efforts. GeoEye looks ready to make significant gains in the remainder of this year and into next year after the launch next Thursday of its newest satellite (GeoEye-1).

GeoEye leads the market, in terms of revenue, in operating satellites that capture geospatial images used by government and businesses. Its images are used by such customers as Google Earth, the U.S. Department of Homeland Security as well as agriculture companies, city developers and planners, real estate developers, video-game makers and companies that develop location-based applications. GeoEye offers a whole set of tools and services for customers to package its images (including historical images from its library) and help them analyze and dissect the information.

What first attracted me to small-cap GeoEye was its low valuation. It had a trailing price-to-earnings ratio of 12 in February, despite projections of growing earnings by 20% each year for the next five years. Unfortunately, that figure kept dropping until it was below 6 in early July.
Up until the last couple of quarters, when the company started losing some orders to competitor DigitalGlobe, which currently operates the newest satellite in the sky, GeoEye was generating $200 million in revenue with operating margins in excess of 45%. If you assume a rapid return to these numbers (and likely higher) once GeoEye-1 launches next week, this company's shares can be bought for just above 4 times next year's earnings.

The company's stock price has slumped in the past six months for several reasons. Its planned launch of the GeoEye-1 satellite had been delayed several times and investors have worried it would be delayed again. The successful launch of the satellite is a gate for future earnings potential. Until the launch happens, however, customers will go to GeoEye's competitor, which currently has the best satellite in the sky.

Other uncertainty has weighed on the stock price. GeoEye announced earlier this year that it would need to restate a small part of its previous year's earnings based on advice of its accountants to ensure they had properly accounted for previous net operating loss carry-forwards.

One of GeoEye's greatest problems has been poor communication. Management has done a lousy job outlining its competitive advantages to investors. This poor communication only exacerbated investors' concerns about the GeoEye-1 launch delay and the earnings' restatement.

It got so bad that one analyst, during the first-quarter earnings call, excoriated GeoEye's CEO and CFO for their poor job of communicating. He directly blamed this failure for the company's low P/E ratio.

Positive Signs

But some things have gone on behind the scenes in the past six months that should please investors. First, GeoEye's No. 1 competitor, DigitalGlobe, filed to go public. This meant it had to open its books to the public in an S-1 filing with the Securities and Exchange Commission, a disclosure that revealed it was smaller than GeoEye. DigitalGlobe's decision to go public also allowed Matthew O'Connell and Henry Dubois, GeoEye's CEO and CFO respectively, to speak more freely about their business without fear of giving their private competitor an unfair advantage.

The second thing that has happened is that O'Connell and Dubois have listened to the criticism of shareholders and learned from it. The recent second-quarter earnings call was much improved over previous ones. On the most recent call, held earlier this month, they laid out all the details of the Sept. 4 satellite launch and cleared up what they had recently concluded about their recent restatement in a way that comforted investors. The stock has held its recent gains, instead of dropping precipitously as it did after the first-quarter call.

GeoEye has also been responsive to private criticisms I've directed to management, so I would like to give them public credit for this.

When I launched my activist campaign against GeoEye in the spring, I outlined in a letter to GeoEye's chairman and CEO three important but fixable problems I urged them to correct:

1) raising the company's price-earnings ratio through better investor relations and better communication in general,

2) clearing up the earnings delay immediately, and

3) ensuring management and the board had enough "skin in the game" and adding new board members to strengthen the overall team.

I have spoken to Matt O'Connell and Henry Dubois several times since I sent my first letter. In my view, communication with investors is much improved when it comes to discussing what the company is doing to achieve its immediate-term goal of a successful satellite launch, frequent pitching of the strong GeoEye story through investor meetings. Speeches at investment banking conferences have clearly laid out why GeoEye is significantly ahead of DigitalGlobe and why the market for geospatial images is expected to explode in the years ahead.

On its most recent call, GeoEye specifically mentioned how it's spending much more time talking to investors and telling its story. GeoEye is now covered by four analysts (all with buy ratings) compared to the one analyst it had last quarter. GeoEye has spelled out how its newest satellite will be the industry-leader for the next two years until DigitalGlobe launches its next satellite.

Also, last week, they hired their first chief technology officer, whose job it will be to better communicate the technical advantages of GeoEye's images and how they will play a part in the burgeoning location-based services market. This last point is still what has been missing in the recent GeoEye presentations and speeches.

The earnings restatement has now occurred, and it did not prove significant. Past years' lost earnings should be equaled out by a tax credit awarded later this quarter. There has been no cash impact on the company and the company still has a strong balance sheet to see it through the successful launch of GeoEye-1.

In terms of management and the board improving its makeup, there is still some work to do. O'Connell, Dubois and some others on the management team purchased some stock earlier this spring. I had encouraged them to do so as a sign of confidence in the company. Unfortunately, they only bought about $18,000 each. In my opinion, that's not enough -- especially given the generous executive pay they receive.

The CEO, O'Connell, deserves a pass on this issue, as he came from Wall Street to run GeoEye a number of years ago and had to make a big personal investment in the company. I know he understands the concept of "skin in the game." I wish he would encourage other officers and directors to follow his lead. Management needs to realize that stock options given to them as part of their compensation is "found money," compared to open market stock purchases.

On the issue of improving the board, there are already a number of strong individuals on this board, many with a government background (which makes sense as the government is GeoEye's largest customer and a co-investor in the new satellite). This board still could use some people with more of a commercial background, as that's a growing customer area for GeoEye.

However, when I spoke to O'Connell, I made it clear that I was much more interested in seeing the company tell its story effectively, clearing up any restatement uncertainty and encouraging insiders to buy some more stock than discussing the board composition issue. I believe they've prioritized the criticisms appropriately.

The bottom line is that GeoEye has listened to its critics and taken action to address many of the criticisms. Management needs to go further in some areas, but they deserve credit for what they've done to date. As an investor, I feel much more confident in this company's prospects based on my interactions with management and seeing them make some progress against these weak points.

GeoEye's biggest weak point remains communicating its powerful story to investors. It can't rely on its CTO to explain its competitive advantages to Wall Street. This is the job of the CEO and CFO, and they've only improved from a "C-" to a "C+" on their communication skills in the last three months.

All eyes are now on the Sept. 4 launch of GeoEye-1. The company needs to continue to actively communicate with investors on the day of and the day following the launch. The launch team has a 98% success rate over the last 150 launches. After launch, the company will perform tests to ensure everything is working correctly, and its largest customer, the National Geospatial-Intelligence Agency, will sign off that everything looks good at the end of October. That sign-off will allow the agency to agree to a new service-level agreement with GeoEye to buy images in the quarter ahead. Other customers will likely follow.

The launch should therefore have a large catalyst effect on the stock price. A more reasonable valuation for the stock would be 12 times next year's earnings, or triple its current price. It might take a few quarters to get there, but patience and activism are likely to be rewarded.

At the time of publication, Jackson was long GeoEye.

Eric Jackson is founder and president of Ironfire Capital, LLC, and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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