The Boring Portfolio, Mar. 5, 1999

<THE BORING PORTFOLIO>
Coming Down to Earth: Satellite Valuations

By Alex Schay ([email protected])

ALEXANDRIA, VA (March 5, 1999) -- Friday has turned into the "satellite report" recently, and thanks to all the activity in the segment over the last couple of days, this week will be no different. As a group, the "little LEOs" (Low Earth Orbit) as they're known, have really been beaten down.

For Orbital Sciences (NYSE: ORB), the underlying "infrastructure" business is doing well, but the potential legal hassles continue to mount. My colleague Brian Graney (TMF Panic) was humming "Blood in the Water" as I reviewed the growing list of legal teams pursuing class action suits against Orbital (seven as far as I can tell -- but thanks to some law firms re-releasing announcements it's hard to be sure). Even though Congress tightened up the filing laws in 1997 to prevent "greenmail" settlements, it's still pretty easy for shareholders to sue a firm. Even though most companies know that proving "intent" in a financial fraud case involving flexible Generally Accepted Accounting Principles (GAAP) accounting is very difficult, they will usually settle in order to forego the hassle of a protracted legal battle. My guess is that Orbital is eventually going to have to go this orbit, er... route.

This week Iridium (Nasdaqa: IRID) had its secured bank loan debt dropped to B- and its unsecured debt lowered to CCC+ by Standard & Poor's, thanks to a warning that Iridium issued concerning its ability to meet loan covenants tied to its business plan. The company might miss its subscriber and revenue targets for the first quarter. The problem has been laid at Motorola's corporate feet, and Kyocera's as well, with all the shipping difficulties pertaining to the handsets. However, Iridium still maintains that its goal of bringing on 500,000 - 600,000 subscribers by year-end is not in jeopardy. An expanding aeronautics market, coupled with the fact that many of these phones are currently in trials at various government agencies (and having spoken with a really pleased trial user at the General Services Administration), lends some credence to this view.

It might be instructive to get into a little bit of satellite history, before we get into the current valuation issues. Although commercially viable satellite operations providing maritime navigation and communications services were introduced by COMSAT (NYSE: CQ) in 1976, most public satellite companies have seen less than a decade of exposure to the markets. The momentum of technology offerings over the last five years has been on a decided upswing, laying the psychological groundwork for acceptance of satellite services as something more tangible than science fiction. However, over the last couple of months, spectacular failures like the Globalstar (Nasdaq: GSTRF) launch vehicle explosion, delays in Iridium's service rollout, and potential legal difficulties at Orbital Sciences' have hit the "little LEOs" hard.

A whole host of issues related to the coming rollout are now working themselves out. Satellite systems are burdened by horrendous start-up costs, but the promise of low operating expenses and significant cash flow once the systems are in place act as financial balm to both investors and financiers.

The proven market success of Direct Broadcast Satellite systems (DBS), such as DIRECTV, has been a boon to potential voice and data offerings in the last year, with industry pundits proclaiming a broad consumer and investor appetite for satellite services. DBS exemplifies more of an appetite for 500 channels of television than for anything related to satellites. This highlights an essential element of the satellite picture: consumers aren't going to be as forgiving as engineers and technophiles if satellite phones and data devices do not provide reliable, quality connections. A factor that seems self-evident, but is often overlooked in the technology frenzy.

Mobile satellite services were initially conceived to provide telephone service in areas where the cost to build-out terrestrial wireline or wireless networks was not economically justified -- in other words, areas where traditional telephone service just wasn't worth it due to poor population density or "topographically challenged" conditions. Toward this end, satellite services were seen as complementary to land based networks by filling in existing gaps in service provision (a service that virtually all maritime industries embraced).

Some observers feel that the addressable market for satellite telephone booths in the Amazon is rather small, but the important point to remember is that four billion people do not have access to wireline or wireless services. For those with a taste for more substantial demand forecasts, India is often pointed to as a prime example of pent-up demand. Existing networks in India are concentrated in urban areas. With 75% of the population living in villages, and those villages maintaining only 10% of the country's access lines, clearly there is a need for an extension of the network. The demand for lines has been short-circuited by the costly nature of network build-outs into rural areas. The average cost of adding a telephone line is $1500, but the cost of providing equivalent capacity on a satellite network has been estimated at $300 to $400. Industry observers argue that these infrastructure dynamics exist all around the globe, making a compelling case for satellite communications.

Despite these forecasts, present subscribers, like those at at Iridium are primarily high-end business clients that can afford to shell out $3000 for a handset and more for the subsequent voice packages. Fierce retail price competition is years away -- possibly a year or so after Middle Earth Orbit (MEO) operator ICO Global (Nasdaq: ICOGF) gets up and running (in August 2000). A little sooner than that we'll take a closer look at the valuation on the various LEOs -- like sometime next week. Until then, see you on the message boards.

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