VSAT - Why European SES Is The Better Satcom Choice Over Viasat

Summary

• VSAT revenue growth is of poor quality, with challenged profitability throughout its long public history.
• VSAT is faced with new challengers SpaceX and Amazon Kuiper in the consumer broadband market.
• VSAT is far too expensive - investors are encouraged to look abroad for an alternative satcom company. Strong Sell.
• SES S.A. is trading at a 25% FCF yield, with less competition from new challengers.
• SES S.A. is en route to receiving a massive $3 billion windfall this year, worth its entire current market cap. Strong Buy.

Investment Summary

Viasat ( VSAT ) and SES S.A. ( SGBAF ) are satellite service providers that provide networking capacity to maritime, aviation, government, militaries, and consumer markets. The two companies have markedly different core businesses, but both are in a stage of growth buildouts. We believe VSAT constitutes poor quality, competitive growth while SES operates in quality, higher-barrier, profitable growth.

American-based Viasat's core consumer broadband segment is unprofitable and faces mounting pressure from SpaceX's Starlink ( SPACE ) and Amazon's Kuiper ( AMZN ). VSAT currently trades at a 200x P/E, but more of an issue is the company's accelerating free cash flow losses over three years, exacerbated by the sale of its military communication Link16 service to L3Harris (LHX) - the company's only profitable business operation. Investors would be betting on Viasat winning the space-based broadband competition, while contending with large cash outflows, substantial debt, and no history of profitability. Furthermore, there is no indication that consumer markets can support increasing competition for space-based broadband. Risk-reward is skewed heavily to the downside, and this article assigns a Strong Sell rating to VSAT.

Alternatively, the core video data transmission segment for French-Luxembourg SES is extremely profitable at over 60% EBITDA margins, virtually all converting to operational cash flow. This core segment provides substantial cash flow that management is both reinvesting in new business and returning back to shareholders - currently investors receive around 8% dividend yield. SES trades at a 7x P/E and a normalized P/FCF of 3-4x (not including recent payments for its C-band spectrum license sales). There is high visibility toward SES investors capturing an additional $3 billion windfall later this year from the U.S. FCC in a deal with Verizon ( VZ ), while receiving an 8% dividend yield from an incredibly discounted, well-managed satellite operator that has been at the forefront of satellite networking for decades. Risk-reward is skewed heavily to the upside, and this article assigns a Strong Buy rating to SES.

Note 1: The OTC shares of SES ( SGBAF ) are highly illiquid. We would suggest to interested investors to look to the much more liquid ticker, SESG.PA, that trades on the French stock exchange.

Note 2 : This article refers to the European space company SES, and not the battery company, SES AI Corporation. All references to SES are to the former.

The Case Against Viasat: Increased Competition, Poor Quality, and Expensive Valuation

The case against Viasat boils down to three components: first, Viasat's strategic pivot pits them in direct competition with Starlink, Amazon, OneWeb ( ETCMY ), and a growing number of startups; second, Viasat has no history of quality revenue growth and is not expected to turn a profit for several more years; and third, fundamentals on Viasat are extremely expensive considering debt burden, cash outflows, and modest growth.

First, consider competition, primarily SpaceX as the only other operational network, though OneWeb and Amazon seem committed to entering this space in the immediate future. SpaceX prices their Starlink service at $110/mo. , while Viasat has different plans , ranging from $70 - $300/mo. depending on speed and data limit. The chart below shows speed tests for these satellite operators versus conventional broadband internet, demonstrating that consumers who do not live in rural areas and have access to conventional broadband have no incentive to switch, especially as the satellite services are more expensive.

From reported data of 17% of the U.S. population living in rural areas , Viasat has a total addressable market (ex-international) of ~$6.3 billion for the consumer broadband market under SpaceX's pricing model. This estimate is a grossly overestimated upper-bound and assumes every rural U.S. resident purchases their own Viasat plan, and that they do not have access to another (likely cheaper) source of broadband. Viasat management claims a $650 billion total addressable market (including international), which we do not believe is presented in good faith considering the commoditized nature and intense competition of broadband. Unless Verizon ( VZ ), AT&T ( T ), and T-Mobile ( TMUS ) suddenly go belly-up, not to mention international telecom companies, the addressable market is more likely to be significantly smaller and relegated to those without alternative access - directly in competition with other satellite operators.

Regarding business quality, recently, Viasat merged with Inmarsat to double-down on mobile networking, with a strong focus on the aviation industry. Furthermore, VSAT substantially reduced military exposure with a sale of its military communications business - its only decent-quality, profitable segment - to L3Harris ( LHX ), as they try to handle their debt and focus on scaling up their capital-intensive mobile networking in a race against SpaceX. Below are the segment revenues and profits (losses), pulled from the company FY22 10-K :

According to the L3Harris acquisition presentation , the Link-16 sale to LHX was capturing $400 million in revenue at 20% operating margins - a decent business! This means the pro-forma Viasat government segment is $686 million at $80 million operating income. The government segment was the only meaningful cash flow positive segment able to offset the poor business quality of the satellite services and commercial networks. We should also mention that Viasat grew its satellite services revenues by 37% year-over-year, but operating profits only increased 2%, which is not indicative of a business with quality growth.

Finally, on valuation, Viasat has negative cash flows, which will only accelerate with the sale of its decently profitable government segment, and trades at 200x P/E. Perhaps, if we worked hard to stretch our imagination, this would make sense for a company that was rapidly growing quality revenues, but instead the company has been growing revenues at 10% annually of which almost none drop to the bottom line. Unfortunately, we do not see economies of scale coming into play as the ex-government businesses already amount to $1.7 billion with profitability worsening, not improving. Furthermore, Viasat has had decades of very little competition in this space - a luxury no longer realized. We believe that, just like terrestrial telecommunications companies, satellite broadband will become a commoditized race to the bottom for a select few operators.

The Case for SES: Deep Value, Significant Accretive Catalyst, and High Quality

The case for SES involves three components: first, SES is generating normalized free cash flow at 25% of its current market cap; second, the company is on-track to benefit from a massive $3 billion payout for the majority of their C-band spectrum this year; and third, SES is a historically high-quality business and is reinvesting in profitable, high barrier-to-entry markets.

The core business for SES is in video data transmissions, covering 95%+ of the globe and providing the infrastructure, through their satellite networks, to transmit high-definition video from their broadcaster customers. This business has historically provided 60%+ EBITDA margins and annual free cash flows of nearly €1 billion annually for nearly a decade. The business had a drop in cash flow generation and earnings were challenged with the onset of the COVID-19 pandemic due to the shutdown of live sports, which is a major source of revenue for SES. Since then, cash flow and profitability has rebounded with €876 million in free cash flow in full-year 2021 and €200 million expected in full-year 2022. The drop in 2022 is part of the company's significant growth capex reinvestment that will be discussed next.

In 2022, growth capex of €830 million is expected to accelerate the networking business with launches of their O3b mPower medium earth orbit satellites to provide consistent, on-demand, high throughput capacity to heavy data end-users. This growth capex is not expected to last beyond FY 2022 (the O3b mPower satellites are designed to last 10 years even in their radiation-heavy orbits) as the capex spend decreases to around €450 million in 2023 and normalizes to maintenance capex around €300 million, on par with historical operations.

We should note that SES has the distinction of being the only satellite provider with a multiple orbit satellite network infrastructure. Each orbital regime has its own unique advantages, so the significance of this is the ability to relay data to different geographical locations and transition between capacity throughput and latency in real-time in conjunction with ground software, depending on the needs of their customers. This is a material competitive advantage squarely aimed at providing value to militaries and governments. To this end, SES has been accelerating the build-out of their ground segment and partnering with Microsoft ( MSFT ) to leverage cloud technology in delivering data across the satellite and ground networks. Finally, to punctuate their focus on the U.S. military market, SES acquired Leonardo DRS U.S. satcom ground business to scale up the company's U.S.-based footprint and services to the U.S. Department of Defense, and enables them to participate in classified programs, which in-and-of-itself is further barrier to entry.

The astute reader may note that SES has been trading at discounted valuations for a couple years even before 2020, at around a 10x P/FCF. This is primarily due to high visibility of the core business slowly declining by low single-digit revenue annually - a melting ice cube. Broadcasters, telecoms, and cable providers continue to grapple with an increasing number of cord-cutters, which impacts SES as the infrastructure provider for these networks. CEO Steve Collar, who has spent a lifetime in the satellite operations industry, openly acknowledges this issue and has been aggressively investing cash from the core business to grow its networking business aimed at commercial networks, governments, militaries, and fixed sites (i.e., oil and gas infrastructure, remote locations, etc.). The new networks business has been profitably growing at high single-digit/low double-digit revenue in recent years, outpacing the declining core video segment. By Q3 2022, the networks segment contributed nine-month €636 million, nearly half of the total nine-month €1400 million revenue. Compared to the Q3 2018 nine-month revenue of €491 million, the networks business has grown around a 7% CAGR, offsetting the video business decline.

While it is no secret that the video business unit is expected to ultimately die out, SES has a contract backlog of €6.4 billion in just their video business segment, where a typical contract life is 10 years. It is also unlikely that the world suddenly stops watching sports and relying on cable and broadcast networks, so this backlog should be expected to replenish, powered by live sports, albeit at steadily diminishing volumes. Lastly, increased market penetration of 4K ultra-HD televisions will require high resolution data infrastructure support on the backend. While terrestrial fiber optic networks can easily handle this task, fiber connection coverage , at least in the U.S., is still few and far between with AT&T having the most national coverage at a measly 12% . SES's satellite infrastructure is capable of handling this ultra-HD data, so we expect this to mitigate the video business decline in the medium-term. All of this taken together implies that the demise of the company's video operations will be a gentle, dignified decline into obsolescence with at least a decade-long cash flow runway to continue reigniting growth through the strategic shift toward network services for governments and militaries. We believe the market is heavily discounting SES with a myopic, and exaggerated, perception on the immediate death of video data transmission with no credit given to the networks business.

C-Band Clearing Catalyst

As far as catalysts, the most exciting driver is the expected $3 billion payout from the U.S. FCC for more than half of SES's C-band spectrum. In order to receive this payout, SES must abandon and shift out of the 280 MHz lower end of their C-band spectrum , which will be given to Verizon to accelerate the U.S. 5G national rollout. SES will be left with a smaller slice of the C-band spectrum to support their video data customers. Last year, the company received $1 billion in interim payments for meeting a milestone, which SES used to pay off a substantial amount of debt. To receive the additional $3 billion payout, the company by the end of 2023 has to meet final milestones (with Verizon fronting the transition costs). The launched SES-20 and SES-21 satellites are already in service and signify major progress toward this clearing goal. The last launches toward meeting their C-band spectrum clearing goals are expected in H1 2023 with SES-18 and SES-19. If SES meets this deadline in time, the $3 billion payout received will be nearly the entire current market cap of SES.

Management stated that the proceeds of the C-band spectrum clearing will be deployed with a mix of debt repayment, business growth, and shareholder returns. SES had already paid down a substantial amount of debt with their first $1 billion, out of $4 billion, installment from the U.S. FCC. The remaining debt profile is of little impact until 2026 - 2027, when €1.3 billion comes due and which current cash of €1.7 billion and operational cash flow can easily handle. There should be little urgency in attending to the remaining debt, suggesting that a substantial amount of the $3 billion would be returned to shareholders.

Valuation Model

This article will finish with a reasonable analysis valuation for SES through FY 2025.

1. Assume revenue decline of core video business at -3% CAGR.
2. Assume revenue growth of networks business at +8% CAGR (total net company growth of +5%).
3. Assume EBITDA margin of 58% (meaningfully lower than historical rates of 60%+).
4. Assume terminal EBITDA multiple of 5.5x by FY 2025 (in-line with current multiple, implying no multiple re-rating at all; historical average is 7x - 8x).
5. Assume stock repurchase of 30% cash flow (double historical 15% rate given alleviated debt burden and depressed valuation), and debt repayment at 20% cash flow.
6. Assume the remaining 50% of cash flow is earmarked to grow the dividend from the base €0.50/share.
7. Assume discounting factor of 10% to present (historical WACC ~5% - 6%).

Regardless of whether or not SES realizes its C-band clearing payout, we arrive at a FY-25 fair value of €10.91 per share including €2.25 per share in dividends, or 27% annualized CAGR. If SES succeeds in realizing its C-band clearing payout, we expect an additional €4.06 per share, the majority of which is likely to be returned directly to shareholders via a special dividend. All of this is contingent on low growth expectations and no multiple re-rating for a well-run, high-margin business with a cash-printing history.

Risks and Conclusion

This article laid out why we believe Viasat is an expensive bet in a likely to be commoditized segment of the satellite industry. VSAT has yet to prove its business model and appears to have doubled down on the consumer market with its sale of its government business and acquisition of Inmarsat. Investors are risking significant downside in a cash-burning business with the hope that Viasat comes out markedly ahead of SpaceX.

This article also discusses an alternative investment idea in SES S.A. That being said, there is risk here as well, namely the company failing to meet its C-band clearing milestones, but also if management fails to continue growing the networks business. We could also be incorrect in our assessment of the degree and timeline to which the video business deteriorates, putting unexpected strain on the current cash flow. However, we believe these risks are mitigated by the severe discount that SES is currently priced at, and that investors can patiently wait with a nearly 8% dividend while value is unlocked. For U.S.-based investors, know that a tax treaty is in place that offsets the Luxembourg withholding tax on dividends.

The reader should also be aware that the Luxembourg government owns 33% of the company, with reduced economic rights and otherwise no special treatment; however, they hold the extra power to turn down any mergers, take-overs, or acquisitions that would negatively impact citizens of Luxembourg. We believe the government of Luxembourg's stake makes SES more mindful of remaining a profitable, value-generating business; however, it does also mean that a billionaire cannot swoop in to acquire the company and join the favorite billionaire past-time of running a space business.

This article concludes with a Strong Sell rating on VSAT and a Strong Buy rating on SES S.A.

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