Gilat Satellite Networks Ltd (GILT): Post Unavailable Additional Informati...

midastouch017 · 2013-10-31T14:57:56.7630000Z

Gilat Satellite Networks Is Another Attractive Opportunity Caused By Sequestration Oct 31 2013, 10:32 Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...) Key takeaways Gilat Satellite Networks (GILT) trades at a low multiple due to recent budget cuts. However defense represents a shrinking portion of an increasingly diversified revenue stream. Moreover, an activist oriented management and multiple "free call options" provide additional upside potential. Company overview GILT is a global provider of broadband satellite communication equipment as well as networking products and services. Equipment revenue is generated primarily from the sale of VSATs*, hubs, SSPAs, (solid state power amplifier) and low-profile antennas. Service revenue includes access to and communication via satellites, installation of network equipment, telephone and internet services, consulting, online network monitoring as well as network maintenance and repair. GILT operates through three reporting segments: The commercial segment provides VSAT networks, satellite communication products and professional services to service providers and operators. The defense segment provides satellite communication products and solutions to defense and homeland security organizations. The services segment provides managed network services including rural telephony and internet access. The stock also trades on the Tel Aviv Stock Exchange although there is more than sufficient volume for U.S. based investors with average 30 day volume of ~42,000 shares. In March 2008, GILT agreed to be acquired by a consortium of private equity investors for ~$475 million. However in August 2008, the merger was terminated after the proposals received were different from the agreed upon terms. The merger agreement provided for a termination fee of ~$47 million and in August 2010 GILT settled with the consortium for ~$20 million. In October 2013, the court dismissed a $12.4 million lawsuit against Gilat, which claimed damages as a result of the failed merger. *VSATs (very small aperture terminal) are earth-based terminals that transmit and receive broadband, internet, voice, data and video via satellite. Sequestration casualty list keeps growing GILT (along with most defense contractors) is currently suffering from sequestration-related budget cuts, which caused management to lower 2013 guidance. As a result, GILT trades at a mid single-digit EBITDA multiple. However the current multiple fails to reflect four significant mitigating factors. First, the low multiple implies a higher than actual exposure to U.S. defense cuts despite the broad segment and geographic diversity (shown below). The eventual removal or even reduction in sequestration "headline risk" should result in a higher multiple. The weakness in the defense segment is causing a disproportionate effect on the multiple. For example, the contribution by this segment has declined (even before sequestration took effect) over the past several years as a result of numerous acquisitions and organic growth. As a result, any potential negative defense developments going forward should have less effect on overall financial results. Moreover, strength in the commercial segment in the most recent six month period helped offset weakness in the defense segment. A significant and overlooked catalyst is the growth in services revenue (by type not segment). For example, since 2011 services revenue rose from 40.5% to 53.2% and offset weak equipment sales most recently. GILT typically receives long-term maintenance contracts relating to its equipment sales, which provide a significant amount of recurring revenue. A core group of existing customers provide additional revenue visibility. Second, the bullish long-term prospects for the defense segment are being ignored due to short-term concerns for two reasons. First, the strong demand for satcom-on-the-move communications for ground forces (especially given the increasing role of special operations) and other products less vulnerable to cuts should provide greater visibility. The focus on strategic programs (much like NCI) is one of the most effective ways to combat budget cuts. Second, GILT continues to grow internationally through sales to new and existing customers. Third, GILT is a market leader with competitive products and is in a strong growth position. According to the latest report by satellite industry research firm COMSYS, GILT is the second-largest manufacturer of VSATs for the enterprise market with a 24.7% market share. The large installation base provides a platform for incremental sales to existing customers. An example of the competitive products is its patent-protected amplifier that generates high output power in a compact size, which produces less heat, uses less energy, reduces lifecycle costs and provides greater reliability. Fourth, expansion into new markets offsets weakness in the defense segment. There are multiple growth areas with long-term demand drivers including: Internet access on commercial airlines (GILT provides the amplifier for inflight connectivity). Emerging markets with unique operational constraints (e.g. remote locations, challenging terrain, lack of infrastructure) and limited to no existing telephone/internet service. VSAT networks are ideal for these locations as they are reliable, require little maintenance, simple to configure and repair, cost effective and do not rely on local infrastructure (e.g. can be powered by solar panels). Demand for integrated solutions in new markets including consumer, cellular backhaul, oil/gas and banking. GILT is one of the few "turnkey" providers with these broad capabilities and strong reputation. Furthermore, GILT chose not to participate in the most recent bid for telecom services in Colombia last year due to unfavorable contract terms. This focus on the bottom line should not be taken for granted as many companies are willing to grow at any price and usually suffer disastrous consequences (e.g. forced to dedicate resources to long-term, unprofitable contracts). Activist oriented management Management has taken multiple steps during this challenging period (in addition to those mentioned above) to maximize shareholder value, many of which are straight out of the activist investor playbook. First, GILT reduced debt by 33% since 2010 and is currently in a net cash position. Furthermore, it eliminated potential dilution by repaying its convertible subordinated notes. Second, GILT reduced its cost structure through workforce reductions, moving antenna production to Bulgaria and outsourcing almost all of its VSAT indoor units. Third, in August 2013 GILT sold its unprofitable Spacenet subsidiary (provider of managed network services) in order to focus on commercial and defense products and services such as internet access and satcom-on-the-move applications. Strategic investments are potential hidden value GILT has ~$31 million of strategic investments in other companies. However there is a high delta around this value. For example, in August 2010 GILT received more than $24 million from the merger of Ingenix and Axolotl. GILT invested ~$4.5 million in Axolotl over 10 years prior and even wrote off the investment during the economic downturn in 2001. These types of investments (much like real estate) are carried at cost and may not represent the actual market value. NOLs and low tax structure represent a "free call option" on profitability Although GILT has been unprofitable for the past several years, the revenue growth drivers and lower cost structure mentioned above provide a clear path to long-term profitability. Eventually GILT should be able to use its significant NOLs (e.g. $52 million in Israel with no expiration, $256 million in U.S. which must be used within 20 years and $15 million and $32 million in Europe and Latin America, respectively). Furthermore, GILT may be eligible for an Israeli tax exemption. Risks Competition. In addition to other communication equipment providers, GILT faces increasing competition from alternative technologies such as wireless and terrestrial. Customer concentration. In 2012, two customers accounted for ~24% of revenue. Dependent on government spending. GILT continues to be negatively affected by lower U.S. defense spending and is exposed to the risk of lower foreign government spending. Product obsolescence. As the average selling price of communication equipment typically declines during the product life cycle, GILT must continually develop new and competitive products to remain relevant. Conclusion The target price of $5.79 is based on a 7x EBITDA multiple. This is conservative given the higher peer group multiples.