Home >> December 2008 Edition >> Annus Horribilis or Annus Mirabilis?
Annus Horribilis or Annus Mirabilis?
by Hoyt Davidson, Founder, Near Earth LLC

To borrow from Queen Elizabeth II, the year 2008 “is not a year on which I shall look back with undiluted pleasure… it has turned out to be an Annus Horribilis.” Depending on your view of the U.S. Presidential election, you may believe the year had an offsetting “Annus Mirabilis” event or, alternatively, just more Horribilis.

Either way, clearly from a financial point of view, a lot of perceived value evaporated in our heretofore specially protected and recession resistant satellite industry.

In a rush for the door, investors indiscriminately dumped anything and everything that did not look like cash. Satellite companies, which tend to be small to mid cap in terms of trading liquidity, and generally far from investment grade credits, suffered along with most others. In fact, public equity values declined 23 to 95 percent from recent highs, despite the solid operating performance mentioned below and despite wide held beliefs of significant resistance to recessions.

Yields on outstanding satellite company debt also widened significantly. Unless such yields contract again, it will be quite challenging for many companies to raise much needed growth capital or to refinance existing loans as they come due.
When, and to what extent, this value returns (and brings with it renewed investor interest) is a major question for all of us. Just as clearly as financial turmoil and market volatility ruled the day late in 2008, the year also witnessed some important industry accomplishments and progress.

There are also, of course, many challenges facing the industry in 2009 as well as opportunities to consider. Here is a brief summary of how we fondly — but nervously — look back on the year and prepare for the future on a sector by sector basis.

Operational Performance
Satellite industry performance, from an operating point of view, is in large part measured by the health of the important fixed satellite service sector. Most FSS operators have enjoyed mid single digit revenue growth this year. Intelsat reported record revenues for its first six months of 2008, up 9 percent, and Eutelsat reported a 7 percent gain over 2007.

Some firms, such as SES, saw much flatter growth this year. In general, FSS companies are enjoying strong cash flows, good multi-year backlogs, and reasonably high credit quality customers who are dispersed over a variety of economic sectors and geographic regions. Furthermore, the telecom and entertainment markets they serve tend to be critical to their customers or at least resistant to recessionary pressures.

Through October 31st, 2008, a total of 628 36 MHz transponder equivalents of capacity have been added. This capacity expansion was largely driven by the continued explosion of video content worldwide, However, other applications such as private data networks, cellular backhaul, and Internet connectivity, were important factors in addition to continued strong demand from government/military users, particularly from the U.S. While the worsening global economy could have a negative impact on near term demand, we do not see any long term trend other than continued massive acceleration in demand for satellite delivered digital bits. Even with continued advancements in compression and modulation efficiencies, demand for transponders should continue, especially for the developing nations of Asia-Pacific and Middle East/Africa markets.

2008 Advances and Accomplishments
Among the most remarkable accomplishments in 2008 was the launch of ProtoStar, which we understand is now in full ITU compliance. Starting a pan-Asian FSS company without majority Asian ownership is quite impressive.

From a future trend perspective, the other major accomplishment has to be China’s entry into the commercial GEO manufacturing business and re-entry into the GEO launch market with the China Academy of Space Technology manufacture (DFH-4 platform) and Great Wall Industry Corporation launch (Long March 3B) of Venesat-1 for Venezuela. A new low cost provider of space segment capacity could lead to further national fleet additions and to more nations joining the space age, while potentially staving off further consolidation by the “big guys”. We note, however, the flexibility, efficiency, dependability, and geographic reach of the larger FSS operators is hard to debate — consolidation is still a manifest destiny in a deregulating flat world.

2009 and Future Prospects
Going forward, leverage at FSS firms such as Intelsat and Telesat could become an issue, at least from the point of view of operational and strategic flexibility, but we do not envision any near term credit driven solvency issues at any of the major FSS operators. More conservatively levered firms like SES and Eutelsat should be able to handily weather the credit crisis and better exploit growth opportunities, although Eutelsat does have €1.3 billion of debt to refinance in November, 2011. What we believe could happen over the course of a prolonged and deep recession is that access for capital to launch new space segment capacity could become more challenging and expensive.

This could have the effect of making it harder for smaller FSS operators to grow or even replace aging capacity without relying on new lower cost systems as mentioned above. Whether this results in an environment conducive to further industry consolidation is hard to predict, but there could be less capital to support such consolidation anyway. We suspect that the major FSS operators with their large fleets and economies of scale will still be in a preferred competitive position in this challenging economic climate despite any local market subsidization or preferential access.

As for new FSS applications, the one that is perhaps least understood and most under appreciated is wireless backhaul. According to ABI Research, the cellular backhaul market should reach $23 million by 2012. Over half the world’s population, some 3.5 billion people, now carry mobile phones. While subscriber growth is slowing in the developed world it is also shifting to richer bandwidth applications rapidly accelerating digital traffic. In the developing regions, growth is still in the high double digits and in parts of Africa, for instance, in excess of 100 percent. What about the other 3 billion people without cell phones? Tapping this market has not been lost on entrepreneurs like O3b (which even stands for “Other 3 Billion”) or its sponsor Google. Many of these next 3 billion customers live in the rural/remote areas of the world. Bringing them mobile connectivity may require substantial new satellite capacity marking a return to the original telecom purpose of satellites.

Operational Performance
The other major satellite industry driver is the DBS/DTH sector which dominates the various consumer oriented satellite service businesses in terms of revenue contribution and cash flow generation. The DBS/DTH sector had a good 2008 with continued healthy increases in subscriptions across the world. Even in the fiercely competitive U.S. market, DBS managed to gain a little more market share from cable and telcos although DISH Network did suffer a loss of net subscribers driven in some part by the switch of AT&T to competitor DIRECTV. These industry subscriber gains came despite earlier warnings of an overpowering threat from triple-play offerings. Apparently, providing a premium video experience through massive HDTV offerings and subsidized DVRs was enough to hold off the triple-play onslaught and new fiber/IPTV platforms for another year. Equally impressive were increasing ARPU levels and well managed churn rates. The operating results were achieved even despite materially poorer customer service rankings, a trend DBS really needs to reverse in a hurry if it is going to keep its customers in a recession. For the developing world, DTH is expanding rapidly with new satellite capacity. There are three operators now in India and China is considering launching SinoSat-4, its second DTH satellite.

2008 Advances and Accomplishments
The most impressive accomplishment in 2008 has to be the rapid increase in numbers of HDTV channels offered to DBS subscribers and the continued proliferation of DVRs. Building off of 2007 efforts and continuing throughout 2008, investments by DBS/DTH operators in content and customer premise equipment has fundamentally improved television viewing for tens of millions of households. We believe these gains in picture quality and time shifting flexibility will become the new default standard and eventually spread around the world.

2009 and Future Prospects
Churn appears to be on the rise due to greater home turnover and the economic downturn and ARPU could experience pressure as subscribers look for cost savings in their household budgets. On the positive side, the February 19, 2009 analog-to-digital transition in the U.S. could result in a windfall of new subscribers. Most neutral industry observers expect many of these analog broadcast viewers to be spurred by necessity (or marketing offers) to switch to a multi-channel cable or DBS service. Who will win the lion’s share of these new subscribers is up for debate, but it seems clear that we are talking about millions of potential new customers for DBS providers. Past 2009, we do believe the continued growth in IPTV supported by capabilities such as SES Americom’s IP-Prime, further roll-out and penetration of services such as FiOS and U-Verse, and even improved cable triple-play packages will start to put considerable pressure on the DBS providers, particularly in the non-rural markets. To grow and thrive in that market, DBS will need to finally answer the triple-play bundle and offer its subscribers a competitive broadband and VoIP service.

Operational Performance
MSS has also seen respectable subscriber and revenue gains this year, mostly off of mature platforms like Inmarsat and Iridium, but many MSS operators face real financial viability issues. The industry requires a massive amount of new capital and yet has not achieved a fraction of the once promised 8-digit subscriber potential. Meanwhile, terrestrial coverage gaps continue to get filled in by more and more capable networks like 3G/3.5G, Wi-Fi and WiMax. Luckily, these terrestrial networks just broaden the addiction to higher and higher bandwidth connectivity to cell phones and vehicles making the need for seamless mobile connectivity more and more evident. Clearly, it’s not just about voice and low data rate services anymore. Mobile users, especially enterprise, young adults and affluent consumers, are demanding broadband access everywhere for video, other rich media content, large file transfers and high bandwidth interactivity for faster browsing and even gaming.

The largest market is clearly land-mobile which heretofore has been restrained by inadequate equipment form factors (e.g. brick phones), poor usability and costs too high versus required mass market price points. Years of investment and technology evolution have come a long way to solving many of these user issues (as have restructured balance sheets). The new Iridium 9555 phone is one example of the tremendous progress made. Demand in aerial and marine applications has also grown materially in 2008. In fact, for much of the aerial/marine MSS market the demand for bandwidth from crew and passengers has become sufficiently large to afford FSS versus MSS solutions.
The same can be said for the Comms-on-the-Move market where military demand for such things as imagery and mapping applications forces an FSS solution. We expect to increasingly see this blurring of MSS and FSS as mobile bandwidth requirements increase. For now it is easier to think of MSS as being the L-band, S-band business and FSS being C, Ku and Ka-band.

2008 Advances and Accomplishments
There have been several notable accomplishments this year in the MSS sector. The one with the greatest near term revenue impact was the completion of the Inmarsat-4 fleet and roll-out of the BGAN service for both maritime and land-based customers. ICO finally got a bird up which allows it to retain its spectrum license and do some testing. One more launch and they can lay claim to their own ATC spectrum. ICO also won a nice settlement from Boeing, but the market appears to be heavily discounting either the amount or timing of this windfall. On the spectrum consolidation front, Harbinger helped push an agreement between L-band competitors Inmarsat and MSV that should be a win-win for both and hopefully trigger some much needed consolidation in the MSS sector. 2008 was also a big year for ORBCOMM, the only surviving Little LEO. They launched 6 satellites on June 19th (5 replacement birds involving new payloads on old Orbital buses and 1 Coast Guard demo satellite) and in May entered into a $117 million contract with Sierra Nevada Corp. for 18 higher functioning satellites. Finally, following the demise of Boeing’s ill-fated Connexion Mobile internet service to aircraft, Row 44 stepped into the gap with their own new satellite based internet to aircraft offering, which began trials on Alaska and Southwest Airlines. Competing terrestrial solutions from Live TV, Aircell and others also entered the fray.

2009 and Future Prospects
In 2009 and 2010, new more powerful MSS satellites are expected to enter service from TerreStar, MSV, ICO and others in hopes of satisfying this growing demand for “any content, anywhere, anytime, to anyone”. What needs to happen in this time frame is smart industry rationalization. Europe is presently going through its S-band (2 GHz) licensing process with four participants so far. The one thing the world does not need in this capital constrained economy is a build-out of four or more redundant mobile connectivity infrastructures for any region. Competition is wonderful, but hopeless redundancy makes no sense to investors and ultimately, therefore, to consumers.

The most important MSS spark that has yet to be ignited is serious interest from the terrestrial mobile providers such as the major cellular companies. The dream is that they invest in or acquire MSS providers to offer a seamless hybrid always-on service. Perhaps the past reluctance of cellular providers has been due to an underwhelming MSS market opportunity compared to the gargantuan lower hanging fruit of the rapidly growing terrestrial wireless/cellular markets.

While the relative market opportunity may still be small, a desire to better serve and thus retain the connectivity addicted may prove to be the greater motivating factor going forward. Now that MSS form factors and pricing per bit are improving, especially with the upcoming launches of new MSS satellites, it should only be a matter of time before certain niche mobile users demand hybrid services and force the hands of the cellular players. This is what many MSS investors are betting on. Just as GM’s introduction of XM Radio in its cars quickly forced a response by Ford, Chrysler and then all other major auto manufacturers, the hope is that the first cellular domino to fall will quickly lead to a global alignment of the terrestrial and space mobile players. But, it does not have to be a strategic alignment with the cellular world. Others, such as Google, are looking to get into the business. The FCC, in an attempt to eliminate the “digital divide”, is doing some clever repurposing of spectrum to bring about new wireless broadband services. Recently they opened up whitespace spectrum for free unlicensed use and even approved Globalstar’s use of its ATC spectrum for a rural WiMax type service. The end game in the wireless world is still far from predictable.

Satellite Radio
Operational Performance
Satellite radio is still a relatively small contributor to overall industry revenues. That is not to belittle the now approximately 20 million SDARS subscribers for the newly merged Sirius XM, but as SDARS has not proven commercially viable outside the U.S. (and maybe not even in the U.S.), it has yet to reach its full potential. In particular, this year marks the demise of much of WorldSpace, the very first SDARS company and developer of many of the key technologies. It is safe to say there would not be an XM Radio and perhaps not even a U.S. SDARS industry were it not for the early visionary work of Noah Samara and the Worldspace team. Alas, the pioneers in this industry rarely reap the full fruits of their labors.

2008 Advances and Accomplishments
The biggest accomplishment in 2008 was clearly the FCC approval of the Sirius / XM merger despite heavy Congressional and NAB opposition. Such courage and sanity in an election year is rare indeed, but the increasingly obvious and intense alternative audio competition together with a willingness on Sirius’ part to accept various consumer protection provisions were enough to carry the day.

2009 and Future Prospects
In the U.S. market, Sirius XM faces a daunting $1 billion debt refinancing before it can begin to enjoy its promised merger synergies. This is not the credit market one would want for such a refinancing, especially when your #1 distribution channel is experiencing automotive sales declines of 25 to 40 percent. Our expectation is that there is enough subscriber value to save Sirius XM, but that equity shareholder dilution will be painful if not total. On the bright side, it is encouraging to see OEMs and Delphi opposing the FCC’s mandate for integrated HD/Satellite radio receivers as unduly burdensome on consumers from a cost point of view. The automotive OEMs have always preferred satellite radio, and the install fees and revenue participation, to a HD Radio alternative that is not even ubiquitous. Nonetheless, we do expect increasing HD Radio competition as someone will build the receivers. Lastly, we expect sometime in the next three years we might see an SDARS provider emerge in Europe. Europeans are increasingly becoming “united” and pan-European and want their music options to match. Our bet would be ONDAS, but it could be any of the S-band competitors even if only as an adjunct to a mobile video or voice/data offering. We wish them all luck in what has proven to be a very tough business. The key may be not owning the expensive space segment, but focusing instead on the content and listeners.

Satellite Broadband
Operating Performance
The surprise subscriber success story this year was the emergence of a vibrant satellite broadband sector led primarily in the U.S. by Wildblue and Hughes (Spaceway), but also showing considerable life in other regions. HughesNet, for instance, finished its 3rd quarter with 420,700 customers, adding almost 15,000 net subscribers each month. We believe Wildblue may have enjoyed similar monthly subscriber growth. Europe has also joined the satellite broadband party with estimates of as many as 37 million undeserved homes in the European and North African regions. SES’s Astra2Connect launched in mid-2007 saw continued growth in 2008 and Eutelsat started its Tooway service with plans to add a new Ka-band satellite for 2010. In the U.K., Avanti Broadband has a new satellite scheduled for 2009. The once questionable Ka-band has now been broadly accepted as an important new industry resource to be further exploited.

2008 Advances and Accomplishments
The launch of the Spaceway III service was the major highlight of the year and a factor in satellite broadband subscriptions exceeding the one million mark. However, given that the Yankee Group in 2004 predicted 12 million subs by 2008, we are still a long way from living up to earlier industry projections and hype.

2009 and Future Prospects
The one thing that seems certain for the future is the eventual construction and launch of massive capacity spot beam Ka-band satellites such as the one proposed by ViaSat. The market demand and technological viability of Ka-band satellite broadband was proven this year, but the lingering investor concern is that of the length of the market window to enjoy an adequate return on the capital employed. The key to keeping that market window open against other gap filling alternatives like wireless broadband, DSL, cable and fiber is to substantially lower the cost per bit so satellite broadband users can enjoy increasingly more bandwidth per subscription dollar. For that to hold, we will need 10x and eventually 100x gains in capacity per dollar.

The Stage Is Set For 2009
In conclusion, 2008 was another year of significant achievements by the satellite industry. Regrettably, these achievements have largely been lost and overwhelmed by larger global economic considerations. We are, however, optimistic about the future, as history has taught us well that while value is not always recognized when created, if true and lasting it is eventually rewarded. Or, as Rene Anselmo used to say, “truth and technology will triumph…..” Speaking of which….way to go Elon Musk and SpaceX team!

About the author
Hoyt Davidson is the founder and Managing Member of Near Earth LLC, a New York based investment banking firm focused on the satellite industry and certain sectors of media and telecom. Before founding Near Earth, Mr. Davidson was a Managing Director in the Telecom Group at CSFB and prior to that a Managing Director and co-founder of the Space Finance group at DLJ.