GeoEye Q2/2008 Earnings: Slight Problems But Otherwise Looking Good

GeoEye, Inc. (GEOY) a provider of space-based and aerial imagery, and geospatial information, reported its fiscal 2nd quarter 2008 earnings on Tuesday after the market closed, and updated the launch status of GeoEye-1, which has been delayed once again, this time for about another 2 weeks.

While I wrote previously that I did not expect the Q2 earnings to be anything special (they weren’t), GeoEye surprised me with a further delay in the launch of GeoEye-1, albeit only slightly, and also had some accounting problems that I will detail in full.

What follows is a summary of GeoEye’s earnings announcement and conference call, a discussion about the delayed launch of GeoEye-1, along with my explanation of the numbers and outlook, and what you need to know to fully understand the GeoEye story.

Sales, Profit Down as Expected Here are some of GeoEye’s earnings highlights (growth from previous year’s Q2/analyst’s estimates where applicable. There are now 4 analysts that cover GeoEye.):

• Quarterly sales of $34.2 million (down 29%, from $48.3 million in the prior year/vs. $35.10 million projected by analysts)
• Quarterly operating income of $5.3 million (down 79.4%, from $25.7 million in the prior year)
• Quarterly net income of $2.4 million, or $0.12 per diluted share (down 79.3%, from $11.2 million, or $.58 per diluted share, (this was restated from $23.4 million due to a tax restatement, as explained below)/vs. $.14 per share projected by analysts)
• Gross margin of 43.5% (down from 68.6% from prior year)
• Operating margin of 15.4% (down from 53.3% from prior year)
• Net margin of 7.0% (down from 23.1% from prior year, which was restated due to a tax restatement, as explained below)

My Take: These numbers look pretty bad don’t they? Aside from coming in right around Wall Street’s estimates, everything else fell off quite a bit.

But what you need to understand first and foremost, is that these numbers are MEANINGLESS both to me and Wall Street.

You see these lowered numbers are as a direct result of the delayed launch of GeoEye-1, which was originally supposed to launch earlier this year, and the fact that the National Geospatial-Intelligence Agency (NGA) has given some of their commercial satellite imagery contracts to GeoEye’s only competitor, DigitalGlobe (DGI).

We all knew this would happen, and as the government looks for better imagery to fulfill their needs, because GeoEye-1 has not been launched yet, that business is being given to DigitalGlobe.

Most of the NGA’s current backlog of imagery orders for GeoEye centers on that imagery coming from GeoEye-1, and as such we’ll see a huge uptick in revenue and profits once GeoEye-1 is launched and the order flow starts to trickle its way through.

The investing thesis in GeoEye revolves around the future launch of GeoEye-1, and not the past results from the satellites that the company currently has in operation.

So take this quarter and most likely next quarter’s results with a grain of salt, as they don’t tell us what’s really going on here and why an investment in shares of GeoEye is prudent.

In addition, as I’ll discuss later in my report, GeoEye had some one-time tax and internal control issues that they were dealing with this quarter, and therefore had to restate their earnings for prior years, which changed some of the comparisons dating back to last year.

This seems to be a temporary and one-time event that I’ll explain in more detail below.

Finally, the primary reason for the decline in margins, and operating and net income, was due to the lower NGA imagery orders as described above.

As explained before, the reason for the sharp decline in margins lies in the fact that GeoEye, in order to fulfill some of their requirements to the NGA, their largest customer accounting for about 55% of total revenue, has to purchase imagery from other vendors and their own subsidiaries and then sell that back to the NGA from time to time.

In addition, the NGA sometimes asks GeoEye to scan and “scrub” certain imagery that proves more time-intensive and costly for GeoEye because it comes in bits and spurts, rather than all at once.

All of this affects margins heavily.

Going forward, once GeoEye-1 is launched and orders get more smoothed out and GeoEye starts to fulfill their NGA backlog, margins will jump back up and more revenue will drop to the bottom line since less resources will be spent doing spot work and more will be spent on a bevy of projects at the same time, thus reducing operating costs.

This is where the beauty lies in GeoEye’s business model.

The more revenue they generate on the top line, the higher their margins increase because they have fixed costs.

Bottom Line: Pretty simply if you ask me.

No GeoEye-1? Lower revenue, margins and profits.

GeoEye-1 launched and fully operational? Huge surge in order volume, higher revenue, higher margins, higher profits.

Let’s look at some other aspects of GeoEye’s latest quarter.

GeoEye-1 Launch Delayed Slightly

• Through no fault of GeoEye’s, the launch of GeoEye-1 has been delayed for a couple of weeks and is now tentatively set for September 4th, 2008 instead of August 22nd. I’ll explain why below.
• GeoEye’s cash balance as of June 30th, 2008 was $221.5 million as compared to $234.3 million on December 31, 2007
• As of June 30, 2008, GeoEye has expended approximately $421 million of the $502 million for the launch, build-out and insurance on GeoEye-1.
• The remaining $81 million includes insurance premium payments (which were made in July and August, 2008), final amounts due to contractors and contingencies.
• Total cash needed to complete the program, including contingencies, are $124 million.
• GeoEye was able to secure an additional $50 million in total-loss insurance, for $6.1 million in premiums. This gives them $320 million in total coverage on GeoEye-1 including launch, on-orbit, and first year on-orbit insurance.
• No cash flow provided because GeoEye was still working on their 10-Q as a result of the aforementioned tax restatements.
• GeoEye does not provide forward guidance, which I like.
  

My Take: I’ll discuss this in more detail below, but the highlight of this conference call was the delayed launch of GeoEye-1 and the reasons behind it.

GeoEye did not provide other details like cash flow because they were not able to release their 10-Q on time, which in turn would have provided cash flow figures and other pertinent information.

This information should be out before the weekend.

Once GeoEye-1 gets closer to actual launch, the remaining contingencies and insurance payments will be due, and GeoEye will most likely see a huge drop in cash flow and free cash flow in the 3rd quarter as it relates to these activities, which are already fully funded.

Everything else was business as usual, with no real surprises in terms of GeoEye’s business operations aside from the tax restatements, which will have almost no material impact on GeoEye’s financial condition, and the slightly delayed launch.

Further Details on Delayed Launch, Tax Restatements The following are the highlights from GeoEye’s analyst conference call:

• GeoEye-1 Launch Delay: GeoEye announced on Tuesday before they released their earnings, that the launch of GeoEye-1 has been delayed through no fault of the company’s.

GeoEye-1

The launch has been tentatively rescheduled for September 4th, which the company feels will be confirmed within the next few days.

As has been the case with the repeated launch delays for GeoEye-1, the reasons for this launch were completely out of GeoEye’s control and leave one to wonder how anything ever gets launched.

United Launch Alliance (”ULA”, a joint venture between Boeing (BA) and Lockheed Martin (LMT)) which is handling the launch, reported a problem with one of the pieces of equipment that is necessary to track and help deliver the satellite to space.

The problem has to do with what is known as a telemetry-relay aircraft that is unavailable to support the launch.

You see, when a rocket is launched, it initially talks to the ground station where it was launched from for directions and instructions.

The problem is that once the rocket passes a certain point in the atmosphere and passes below the Earth’s horizon, communication with the rocket is no longer possible via the ground station, and must be performed by an airborne aircraft, or in this case, what is known as the “Big Crow” telemetry-relay aircraft.

It seems that there was some problem with the aircraft, and it was undergoing repairs.

So, in its place, ULA has instead contracted the services of an instrumented ship known as an Ocean-going Transportable Test and evaluation Resource, or OTTR.

GeoEye-1 on Delta II Rocket Booster

The vessel will be positioned in the Pacific Ocean well downrange from the launch base to cover the initial firing of the second stage that puts the rocket into a preliminary parking orbit around the planet.

There is one more small detail that needs to be worked out and that deals with the re-test of a Range Safety antenna on the rocket booster.

This re-test is scheduled for completion on August 16 and from what I gathered from the conference call, was on track and looking good.

In addition, the Delta II’s rocket boosters are set up and ready to go and GeoEye-1 has completed all it’s check-outs and tests and is awaiting only ULA’s final tests with the telemetry antennae.

My Take: So, through no fault of GeoEye’s, they are once again delayed in their launch by about 2 weeks.

Unfortunately, we as investors and GeoEye as a company, have no choice in the matter, and have to just go with this delay and hope there are no more additional delays.

Regardless, this shouldn’t affect GeoEye’s prospects that much since a two week delay won’t affect the imagery that will be gathered in the back half of 2008, and more importantly, 2009.

As the CEO stated on the conference call: “Changes in schedule for launches are a regrettable but a routine part of launching.”

• More Launch Details: Management reiterated that the last 82 Delta II rocket launches have been successful, with a 98.5% success rate overall, and General Dynamic (GD) and ITT Corp. (ITT) each have a 100% mission success rate for their satellites and cameras.
• Tax Restatements: With their earnings release GeoEye reported today that they are also restating their financial statements for the years ended December 31, 2005, 2006 and 2007 and quarterly information within those years, as well as for each of the quarters ended September 30, 2007 and March 31, 2008.

Without going into too much detail that would not only bore you to tears, but also require a financial accounting degree to understand, it seems that GeoEye misstated some of their earnings and ways in which they accounted for revenue from the NGA, among other issues that have lead to this restatement.

Some of the problems were:

1) GeoEye discovered that it had not correctly included cost-share payments received from the U.S. Government under the NextView program in its taxable income.

2) GeoEye lost the use of net operating losses although they lost fewer net operating losses than reported in their 10-K for the year ended December 31, 2007. This resulted in a decrease in income tax expense and related tax liabilities from the amounts reported.

3) In connection with an internal review, GeoEye identified a decrease of $3.0 million in direct expenses in 2007 due to an overstatement of imagery purchased from third parties associated with imagery sales in 2007.

Whew…follow all that?

There’s a lot more to it, and I purposefully oversimplified things for my brain and yours, but suffice it to say, GeoEye had a few accounting issues within the last 6-12 months that are just coming to light now.

The tax restatements on the change in ownership, and the Net Operating Loss (NOL) carryforwards should not have any affect on GeoEye’s tax liabilities, financial condition, revenues or earnings, and the CEO stated that they are glad to clean things up and move forward.

GeoEye also secured a new accounting firm as a result of this fiasco.

My Take: After all was said and done with the restatement of this, and the restatement of that, it all boiled down to just shifting around how things are accounted for on their balance sheet and income statements.

There will be a $33.1 million restatement this quarter that will impact the bottom line that will be added back next quarter.

This will in essence cancel each other out as a result of GeoEye’s restatements and leniency by the IRS in not assessing GeoEye any tax penalties for their missteps.

Basically, this was a lot of hullabaloo over not much impact to GeoEye’s finances.

• Discussion of the Imagery Market, Online Portals, BASIC Program, etc.: The CEO briefly touched on GeoEye’s growing sales to the online marketplace and how they expect sales in this segment to grow further after they launch GeoEye-1 and have more imagery on portals like Google (GOOG), Yahoo (YHOO), and Microsoft (MSFT), among others.

In addition, on May 29th, GeoEye’s imagery that was embedded in a video-game debuted in Paris to great reviews as to the realism that GeoEye’s imagery added to the game.

The game was developed by UbiSoft and will be launched early next year.

I just thought this was something cool to look out for and another way in which GeoEye’s applications are being used in new markets.

GeoEye also stated that as a result of larger orders for their imagery products and services, GeoEye is expanding their St. Louis facilities by 50%, and will increase headcount accordingly to service the increase in business for this segment of their offerings.

It should be completed by year end.

The CEO also talked about the Broad Area Surveillance Intelligence Capability (BASIC) program that has been talked about extensively in the press and that I touched on, whereby the U.S. government might build and launch their own commercial imagery satellites that might compete with GeoEye.

According to the CEO, GeoEye has not been notified about which way things are going, and the government is still considering many different scenarios.

The CEO reiterated that from their perspective, the commercial sector can always build and run things cheaper than the government usually does, so from a cost savings standpoint, it makes more sense for the government to support GeoEye than it does for them to try and build things and start from the ground floor.

Also, if the government where to choose to run their own commercial branch within a satellite imagery segment, it would run counter to two presidential directives according to GeoEye.

Finally, it looks like GeoEye is getting more and more interest from customers in China, Russia and India, and look to secure more business with these countries as things move forward and with a successful launch of GeoEye-1 and with the added capabilities that GeoEye will have utilizing both their IKONOS and GeoEye-1 satellites.

In addition, GeoEye has signed a third ground station upgrade contract to receive images directly from GeoEye-1, and other customers and affiliates have also shown interest in signing up for GeoEye-1 imagery, but are of course, waiting until a successful launch to commit.

My Take: All good stuff here.

Even in light of the possible government spending to produce their own satellite imagery for the commercial space, it seems like that is less likely to go through than continued utilization of the two commercial providers, GeoEye and DigitalGlobe, especially with the coming change in presidents and because GeoEye makes a very good point that no government agency would ever service the commercial sector (IRS anyone?) better than a private company that is for profit.

• Investor relations: The CEO commented on how GeoEye has worked hard to improve their communications with investors by giving more interviews and speaking at more conferences, and noted that the stock is now being followed by 4 analysts instead of just one previously.

I can personally attest to this with my recent interview with the CEO and CFO, as well as the fact that GeoEye put out a press release with their earnings for the first time ever, and are putting out more and more press releases explaining things in more detail about their business such as the tax issues as well as the delay in launch of GeoEye-1.

You may also recall on the last conference call how an investor chastised management for their lackluster reporting and communication with Wall Street.

In fact, things were so tame and informative by comparison this time around, that one of the analysts on the call even gave props to management for running such a smooth conference call and being so informative and forthcoming.

My Take: You’ll notice that the stock barely budged today even with “poor” earnings, a delayed satellite launch, and some earnings restatements, things that would usually slaughter a stock.

This is as a direct result of GeoEye’s improved communication with Wall Street and investor’s understanding of what it all means.

Now, while I do agree that things have gotten better, GeoEye probably should take a look at who writes their press releases and please ask them to write things in English rather than analyst speak, as some of the press releases, the earnings release being the foremost on my mind with all the tax jargon, are sometimes extremely difficult to follow even for me, let alone someone who is unfamiliar with the GeoEye story.

Investing Thesis Remains the Same While not the deep value that it once was, GeoEye is still an undervalued stock that should be added to your portfolio immediately.

With the upcoming launch of GeoEye-1, yes it will eventually happen, and the improved fundamentals and revenue that will come with it, GeoEye is firmly positioned to capitalize on the recent market downturn, and the misinformation about their stock.

The fact that 4 analysts now cover GeoEye (all with BUY recommendations) when only 1 analyst covered the company just 2 months ago, should tell you something about the added exposure and trust that GeoEye is garnering among the analyst community and Wall Street at large.

It won’t be long before more and more investors and funds move into GeoEye especially before and right after a successful launch of GeoEye-1.

This has also largely been reflected in GeoEye’s stock price recently which has risen from the $16-17 level that I re-recommended you purchase shares at, to the current $24 level, which still leaves plenty of room for upside potential.

The slight problems in this quarter aside, remember that you are paying for the future of this company, not the past.

Anything that GeoEye earns from now until after GeoEye-1 is launched is not material to my investment thesis, and GeoEye’s continued execution and huge spike in imagery orders that will follow the launch of GeoEye-1.

When that happens, today’s valuation in retrospect, will look like an absolute bargain.

September 4th is now our new target date for that to happen.

Which means you still have time.

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