Thursday, December 11, 2008 Take the Long View With GeoEye


By Eric Jackson

12/11/2008 1:59 PM EST

GeoEye (GEOY - commentary - Cramer's Take) operates three geo-spatial satellites that take images of Earth up to a color high-resolution of 0.5m. The company sells these images to governmental and commercial customers. Starting next month, these images will start appearing on Google (GOOG - commentary - Cramer's Take) Maps and Google Earth.

The stock trades at a major discount to its earnings potential next year and should appreciate considerably in the coming months. Yesterday, after the close, GeoEye announced a $144 million contract with its largest customer for 2009; this almost equals its trailing 12 months of revenue.

GeoEye is part of a duopoly in the U.S. with DigitalGlobe (a smaller, private and less well-capitalized competitor). GeoEye had been doing $183 million a year in revenue with 45% operating margins until six months ago, when the company gave up some market share to DigitalGlobe, which launched its newest satellite in the fall. GeoEye's revenue and earnings have recently dropped, as customers opted to use DigitalGlobe's newer satellite. The market has punished GeoEye's shares -- especially during the recent selloff of small caps -- taking the price from a 52-week high of $37.37 in January to below $19 yesterday, near its 52-week low.

A number of events are about to happen in the coming weeks -- beginning with yesterday's new contract news -- that should dramatically reverse the direction of GeoEye's shares.

Recall that the primary reason for GeoEye's stock slide this year was that its nearest competitor launched its latest and greatest satellite. In the geo-spatial imagery industry, higher-resolution images keep improving. GeoEye is now about to leap-frog DigitalGlobe's technology, as it launched GeoEye-1, the newest and most advanced geo-spatial satellite in space, in early September. GeoEye-1 will have the best images in its industry in full color for the next 18 months, until DigitalGlobe puts up its next-generation satellite. However, if DigitalGlobe fails to go public during that time, there is a possibility its launch gets delayed, and that would give GeoEye an even longer advantage.

BCC Research estimates that GeoEye's industry market is increasing from $1.9 billion this year to $3.2 billion by 2012. The key buyers of geo-spatial images are U.S. governmental agencies such as the National Geo-spatial Intelligence Agency (NGA) and Homeland Security. The NGA is GeoEye's largest customer, accounting for half of its revenue last year. The NGA also paid half the $500 million in costs to launch GeoEye-1. The agency is therefore expecting to continue to buy a significant amount of images from GeoEye in the coming years. The NGA's investment came, in part, from a presidential directive for governmental agencies to rely as much as possible on buying services and products from best-in-class companies, as opposed to replicating such services or products internally.

Earlier this fall, the Pentagon floated the idea of building and launching some new geo-spatial satellites of its own to supplement its reliance on GeoEye and DigitalGlobe. This plan was quickly quashed by Congress in November, because of budget concerns. This clears the decks for increased business for both GeoEye and DigitalGlobe in the coming six years.

In yesterday's announcement, GeoEye signed a service-level agreement with NGA, whereby NGA will pay $12.5 million a month up to $144 million in 2009. These payments are for planned purchases of images from GeoEye-1. There might be more. If the payments stay at just that level, they will represent a doubling of GeoEye revenue from NGA compared with 2008.

NGA still needs to certify the quality of the images from GeoEye-1. The images are at a high resolution now, but GeoEye is trying to make them even more finer-grained. This certification is expected to happen on Dec. 15 or slightly thereafter. Once that certification takes place, many other commercial and governmental customers for GeoEye's images will likely begin to strike their own deals and purchase the images.

GeoEye's trailing price-to-earnings ratio yesterday was below 9. Its forward P/E, assuming it does $250 million in revenue next year with 45% operating margins, is 3. Other satellite and space/defense companies trade currently at forward P/Es of 7 to 21.

The key reason why the stock has been at depressed levels since the launch is that it wasn't yet clear that the satellite was operating properly. Yesterday's announcement suggests that NGA is ready to spend money on the new images from the satellite once it certifies the images. NGA's planned spending next year almost equals GeoEye's 2007 total revenue of $183 million, after which the stock hit its all-time high of $37.37. That stock price was achieved prior to worries about delays in the launch of GeoEye-1 that depressed the stock.

The table has now been set for significant revenue and operating margins to accrue to GeoEye over the next 18 months, as NGA, Google and other commercial and governmental customers purchase these images. It is highly unlikely that a technical flaw will crop up this long after the launch. The customers who buy these images (e.g., governmental agencies and Google) are also much less affected by the broader economic malaise compared with most companies operating today.

Assuming GeoEye can double its sales and earnings by the end of next year and is rewarded with an increased price-to-earnings multiple more comparable to its related peers, I believe it could trade up to between $60 and $80 by early 2010, up from its current price of $19.

Days before GeoEye launched GeoEye-1, the company announced a relationship with Google. GeoEye would provide its images from GeoEye-1 to no other online portal except Google. Google is not under any restrictions, meaning it could still buy images from DigitalGlobe. No financial details about the agreement between GeoEye and Google have been released. The first hint of what those details might be won't come until early February, when GeoEye holds its fourth-quarter analysts' call.

However, here is what we do know about the relationship and about Google's interest in space:

  • Google's co-founders (Sergey Brin and Larry Page) attended the September launch of GeoEye-1.
  • Google's logo was on the side of the rocket that launched GeoEye-1.
    Google will begin using images from GeoEye-1 on Google Maps and Google Earth in January and start paying GeoEye for them.
  • GeoEye recently paid Google to get its help in improving their search tools so that GeoEye customers could more easily search GeoEye's inventory of images. (DigitalGlobe has no comparable search tools to offer its customers.)
  • Google's first acquisition post-IPO was for a small company called Keyhole, which is now the basis for Google Earth.
  • Larry Page has signed up to be launched into space himself in 2011.
  • Google has recently been investing in building up its relationships with the federal government, to which it sells its Search, Apps and Earth products. Recently, Google was a Gold Sponsor of an NGA Industry Day, of which GeoEye was also a sponsor and DigitalGlobe wasn't.
  • Google received special permission from NASA to land its corporate jets at Moffat Field near its Mountain View, Calif., headquarters.
It's difficult to say what this adds up to in terms of a long-term relationship between GeoEye and Google. It's quite possible that Google would look to acquire GeoEye in the future to control the images and search tools from GeoEye and develop a deeper relationship with the NGA and the federal government. And Google could be interested in the possibility of designing proprietary search-imagery applications to use within Search and Android (its mobile operating system used in Google's G1 mobile phone). Google is deeply interested in space and space-based imagery. What is clear is that the market is assigning no value to GeoEye from its ongoing revenue relationship with Google or the possibility that Google might acquire the company in the future.

When GeoEye-1 was launched in September, the company said that the NGA should certify the satellite's operation and sign off on a service-level agreement (outlining its planned imagery purchases from GeoEye) within 60 to 90 days. The service-level agreement with NGA was signed on Tuesday, and certification is expected within the week. Expect new customer announcements to trickle out, now that NGA has gone first. In February, GeoEye will hold its next analysts' call, at which time it should start to shed light on its revenue ramp-up with the GeoEye-1 satellite and on the expected revenue from the Google relationship.

Four remaining risks could negatively affect the stock:
  • The satellite could suffer a technical error whereby it becomes inoperable. This is highly unlikely at this point but possible. A major malfunction would slash the company's future earnings dramatically. GeoEye has insurance for this scenario, but it would still not prevent a sharp drop in the stock price. This possibility always exists for the lifetime of every satellite.
  • Management offers poor communication. I have been an activist investor in GeoEye since March. Its CEO and management team have done a poor job in managing the Street's expectations and communicating the GeoEye story. This still remains a problem area, despite criticism from me and from other investors. Management needs to win over the trust of institutional investors and hedge funds to see its price-to-earnings multiple increase.
  • The company has had delays in filling the CFO position. In yesterday's announcement about its new contract with NGA, GeoEye disclosed that its current CFO would be leaving. There are many possible reasons for this, and I don't take it as a sign of problems. The company restated its financial statements recently. The board could have decided to make a change. What is important is that GeoEye hire a first-class CFO to fill the role before the next analysts' call in February.
  • DigitalGlobe could move up the launch of its next-generation satellite sooner than 18 months from now. This is almost impossible. In fact, it's more likely that DigitalGlobe will delay their launch, given that it is waiting to go public to raise needed capital, and the IPO window appears to be shut for the foreseeable future.

In GeoEye, you are getting a world-class leader in a growing and recession-proof industry. Its stock has the chance to triple or even quadruple in the next 15 months. What's more, you're getting a call option on a potential buyout by its partner Google. Put it together, and you have a compelling entry-point at these levels.

[Eric Jackson's fund holds a long position in GEOY.]

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