May 19, 2009, 5:54 am

2009-05-04
DGI - DigitalGlobe

DGI - DigitalGlobe plans on offering 17 million shares(assuming over-allotments are exercised) at a range of $16-$18. **Note that insiders are selling 13.33 million shares in this deal, DGI will be selling only 3.6 million shares in this 17 million share deal. Morgan Stanley and JP Morgan are leading the deal, Citi, Merrill Lynch and Jefferies co-managing. Post-ipo DGI will have 47 million shares outstanding for a market cap of $799 million on a pricing of $17. IPO proceeds will be utilized for general corporate purposes.

Morgan Stanley, the lead underwriter in this deal, will own 30% of DGI post-ipo.

**DGI will have $200 million in net debt post-ipo. Actual debt will be $341 million, while cash on hand post-ipo will equal $140 million assuming over-allotments exercised. DGI would be a much stronger company post-ipo were insiders not making up the bulk of this deal. DGI participates in a hefty capital expenditure sector, launching and operating satellites. I would much prefer to see a debt free DGI post-ipo than one with debt on the books. Had insiders waited until the lock-up to begin selling, it would have allowed DGI to offer the bulk of shares in this deal and pay off some of the debt on the books. That is not the case however.

From the prospectus:

'We are a leading global provider of commercial high resolution earth imagery products and services. Our products and services support a wide variety of uses, such as defense and intelligence initiatives, mapping and analysis, environmental monitoring, oil and gas exploration, and infrastructure management.'

High resolution satellite operator helping companies and governments map the physical world.

DGI currently operates two high resolution imagery satellites which produce DGI's earth imagery content which allows customers to map, monitor, analyze and navigate the physical world. DGI's imagery is currently used in location based applications including Google Maps and Microsoft Virtual Earth, and mobile devices from vendors such as Garmin and Nokia. DGI's satellites take both black and white, and multi-spectral imagery, which shows visible color and non-visible light, such as infrared. One million square kilometers of imagery is added/updated daily to DGI's image library. The image library currently houses more than 660 million square kilometers of high resolution earth imagery, an area greater than four times the earth’s land mass. **DGI believes their image library is the largest, most up-to-date and comprehensive archive of high resolution earth imagery commercially available.

**DGI will be launching their third satellite, WorldView-2, in October '09. The WorldView-2 will nearly double DGI's collection capabilities to nearly two million square kilometers per day. In addition it will enable intra-day revisits to a specific geographic area, including collecting up-to-date imagery in those areas of greatest interest to customers. The WorldView-2 will be the only commercial earth imagery satellite with 8-band multi-spectral capability, which has a more robust color palette and enables enhanced analysis of non-visible characteristics of the earth’s surface and underwater. It reads as if the WorldView-2 launch is designed to expand their governmental defense and intelligence based business.

Sector - Estimates peg the 'earth imagery' sector at $1.9 billion in 2007 with expectations of $3.2 billion in annual revenues by 2012. DGI would appear to have approximately a 10%-15% total market share in this segment. Growth drivers include: 1)increase in government reliance on unclassified earth imaging; 2) Growth of imagery usage to monitor economic development; 3) Consumer application growth including internet and GPS.

Barriers to entry are significant. DGI estimates launching a high resolution imagery satellite is a four year endeavor. Factor in the prohibitive cost of launching and maintaining the satellites, the licenses needed, and the inability to quickly replicate DGI's historical image library and you have a pretty significant entry barrier for new competitors. DGI does have one publicly trading pure-play competitor in GeoEye(GEOY). In the financials section, we will compare the two.

DGI's largest customer is the US government in the form of the National Geospatial-Intelligence Agency, or NGA. NGA accounted for 58% of 2007 revenues and 74% of 2008 revenues. 17% of revenues were derived internationally. Approximately 80% of 2008 revenues were derived from government defense and intelligence agencies, 20% from commercial clients. The bulk of DGI's government revenues comes from tasking orders. These would be up to date data directly from the satellites, often following specific directions from the agencies. Only 12% of government revenues are derived from use of DGI's image library. By contrast approximately 80% of DGI's commercial revenues are derived from their image library.

Capital expenditures - As one would surmise, this is a hefty capital expenditure sector. In the past three years, DGI has had capital expenditures of: $83 million in 2006; $238 million in 2007; $142 million in 2008.

Risks - Two large ones here:

1) The loss of government revenues. As most of the competition in the high res imagery satellite sector is non-US based, there is only one company that poses a serious threat to DGI's government related revenues stream. That one company is GeoEye, who recently commissioned a multi-spectral satellite into operations. GEOY's new multi-spectral satellite is anticipated to derive more US government business than their predecessor satellites. **Note** - It appears the US government remains intent on utilizing both GEOY and DGI's imagery. In fact in a recent long term plan from the Obama administration the government will increase its use of imagery from each of the two companies. Currently it appears to this analyst as if there is plenty of revenues from the NGA for both DGI and GEOY. In fact it seems the NGA prefers using two satellite imagery providers and not relying on one company. Of note, the US government has made a mess of their own plans to launch satellites, which has opened the door for strong revenues growth for both GEOY and DGI. There are long-range plans for the US government owned imagery satellites, however nothing is imminent at this time. That alone makes DGI/GEOY interesting public companies.

2) Failure of a timely launch for the WorldView-2 satellite. As DGI will be a public company when the launch is scheduled, any delay or launch mishap would harm the stock price. Should be noted that GEOY's recent satellite launch was delayed a number of times. DGI's first satellite is due to be decommissioned in 2010. Their second satellite(WorldView-I in operation since 11/07) is expected to remain operational until 2018.

Financials

A significant amount of debt on the books at $341 million. Post-ipo, DGI will also have a substantial amount of cash on hand, approximately $140-$150 million. Much of this cash will be utilized the remainder of 2009 on the launch of their new satellite Worldview-2. Most likely come early 2010, DGI will have $300+ million in net debt, compared to $200 million net debt post-ipo.

***Even with the substantial net debt on hand, DGI will only book $3-$5 million in net debt expense in 2009. Most of the current interest expenses will be capitalized under the construction of the new WorldView-2 satellite and will be expensed over the expected life of the satellite under depreciation & amortization. Once the satellite is launched and commissioned and final expenses are in however, future annual interest expenses will revert to that line item. Expect the interest expense line item to grow substantially by 2011.

Revenues have grown swiftly, kicking into another gear after the late 2007 launch of WorldView-1. Revenues in 2006 were $107 million, in 2007 $152 million and in 2008 $275 million. The swift 2008 growth was nearly all spurred by the US defense and intelligence agencies as commercial revenues only grew by 10% on the year. The launch of WorldView-2 in late 2009 should kick start 2010 revenues similarly. The issue with DGI however is 2009.

DGI became operationally profitable in 2006.

2008 - Revenues were $275 million, a whopping 81% increase from 2007. The reason as noted was the commissioning of the WorldView-2 satellite which brought with it a large increase in US government contractual revenues. Gross margins were 90%. The high gross margins are due to capital expenditures going on the depreciation & amortization line to be expensed down over the life of the satellites. Operational expense ratio was 56%, split evenly between depreciation & amortization and GSA expenses. Operating margins were a strong 35%. Factoring in normalized taxes and interest expense, net margins were 21%. **Note that DGI's taxes were at a higher rate in 2008 than they will be as a public company. It appears this was due in part to DGI taking a large tax credit in 2007. In 2008, DGI was actually a bit more GAAP profitable than the numbers appear. Earnings per share were $1.22 in 2008. On a pricing of $17, DGI would trade 14 X's 2008 earnings.

A couple of comments. First of all, DGI is able to legally hide a chunk of their interest expense annually by capitalizing it into the costs of their satellite launches. Unless the company plans another launch sometime in the 2011-2013 window, beginning in 2011 DGI will get hit with an increase in interest expense on their debt. In fact since much of their interest the past two years has been folded into their satellite costs, come 2011 they will be expensing actual debt servicing as well as the depreciating expense on 2007-2010 debt servicing. This is something that should serve to put a bit of a drag on those strong margins come 2011.

Also as DGI actually spent a far greater amount in 2007-2008 in actual capital expenditures than the depreciation & amortization expense lines, the GAAP earnings numbers look much better than actual cash flows. DGI is GAAP profitable, but due to these two accounting rules, DGI's margins look far stronger than the actual cash flows. This is a hefty capital expenditure business and launching two satellites in two years will have cost DGI over $600 million in actual monies. By spreading out the expenses over the expected life of the satellites, come 2011 DGI will actually have stronger cash flows than their GAAP numbers. Currently however, in their launch phase, the GAAP numbers are better than cash flows.

2009 - 2009 is going to be a small step back for DGI. The economic slowdown has slowed their non-contractual government business. Operating expenses however will grow briskly as DGI prepares for the launch and commissioning of their WorldView-2 satellite. While the first quarter 2009 numbers were not yet ready, DGI expects 1) a sequential decrease in quarterly revenues for the March '09 quarter; 2) A year over year decrease for the March '09 quarter; 3) lower profits for the March '09 quarter. In addition DGI is forecasting no revenue growth in 2009, but forecasting increased operating expenses. Yes, the reason is understandable. 2009 for DGI will be the 'in-between' year not benefiting from the commissioning of a new satellite as 2008 was and 2010 will be. I suspect however that the coming lackluster results for DGI in 2009 may be a surprise to some shareholders expecting continued growth. They just will not be seeing it this year. The good news is, the valuation in range factors this in as DGI is not overly pricey at all in range. A quick forecast for 2009:

Revenues should be stagnant again in the $275 million range. Gross margins should again be strong. DGI will see an increase in GSA and depreciation & amortization knocking operating margins to approximately 31%. Factoring in net interest expense and taxes, net margins should be 18 1/2%. Earnings per share for 2009 should be in the $1.05-$1.10 range. On a pricing of $17, DGI would trade 16 x's 2009 earnings.

A quick look at DGI and competitor GEOY.

GEOY: $492 million market cap with $250 million in debt. In 2009 GEOY expects revenues of $262 million and earnings per share of $0.78. GEOY currently trades at 34 X's 2009 earnings. GEOY recently launched/commissioned a new satellite and expects 2010 to be the year that revenues from said satellite begin to spur EPS growth.

DGI: $799 million market cap with $340 million in debt. DGI should have revenues of approximately $275 million in 2009 and earnings per share of $1.05-$1.10. On a pricing of $17, DGI would trade 16 X's 2009 earnings.

While DGI looks a bit hefty in comparison to GEOY on a price to revenue basis, DGI does sport better overall margins. Part of this may be explained by the difference in accounting as GEOY has opted for more a straight line 'expense as you go' approach while DGI has opted to capitalize and depreciate their direct satellite costs over the expected lifespan of that satellite. Both GEOY and DGI should post strong 2010 eps growth and an argument could be made each should trade at a similar market cap and not the disparity we should see if DGI prices in $16-$18 range.

Conclusion - 2009 should be a rather flat year of performance as the company prepares to launch and commission their new state of the art imagery satellite. Investors expecting continued swift growth in 2009 may be disappointed as DGI will go from 80% revenue growth in 2008 to stagnant revenue growth in 2009. The question here is whether or not that is built into the valuation in range. I believe it is, however be prepared for a potential cool reception to DGI's first few earnings reports in 2009 as they should lag 2008's earnings power. DGI is going to have a difficult 2009, however once the WorldView-2 is commissioned, the revenue and earnings picture in 2010 should resemble 2008's impressive year.

Yes debt is a drag here and I would far prefer DGI pay off debt on ipo than insiders cashing out. That is a significant negative here. The flat 2009 is another negative. However, for the potential payoff in 2010 and beyond, the valuation in range here does not appear out of line. This is an interesting ipo and a recommend in range. Note however, this is not an ipo to pay up for as there very well may be a negative reaction at some point this year to DGI's lackluster 2009 operational performance.

Even with the negatives noted, a unique ipo with hefty barriers to entry and a solid future trading 16 X's current year earnings is a definite recommend in range....shareholders though should definitely expect a choppy ride over the next year.