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Kerrisdale Capital: ViaSat, Inc. (VSAT) – Falling Back To Earth

ViaSat considers itself a leader in satellite technology, capable of producing bandwidth economics competitors can’t match. For the sliver of revenue generated from delivering broadband to an airplane, that may be true. For the 70% of EBITDA that comes from delivering broadband to homes and small businesses, it is not. ViaSat provides inferior technology in a hyper-competitive market. The company’s main business is selling satellite-based basic home internet service to U.S. consumers. Unfortunately, its technology is no match for terrestrial internet providers today, let alone over the next few years as terrestrial competitors dramatically increase speed, capacity and coverage through rapid technological advancements. For ViaSat, forced to compete against terrestrial by launching satellites that exhaust capacity in 2-year cycles, U.S. residential broadband is a terrible business destined to fail.

Longs believe ViaSat is insulated from robust competition by its focus on rural households. They believe ViaSat should thrive in a large addressable market of underserved homes, using leading satellite technology to take share against legacy telco and cable operators. Once ViaSat-2 is operational, subscriber trends will meaningfully improve – that’s when a stock stuck in neutral for nearly 4 years will finally lift off.

Every part of this bull thesis is critically flawed.

Based on both speed and capacity, the company’s value proposition has lost every shred of commercial viability since its last satellite launch. Sell-side estimates that call for a tripling of gross subscriber additions, stable churn (customer disconnects), rising margins, and continued inflated ARPU growth are wildly unrealistic. Investors underappreciate the magnitude and timing of technology improvements in competing terrestrial networks that directly impact ViaSat’s target market. VDSL, G.fast, DOCSIS 3.1 and fiber roll-outs are dramatically improving the capability and coverage of landline networks. Wireless 4G LTE is ubiquitous, unlimited data plans are offered by all four major carriers, and massive increases in spectral efficiency are fueling exponential gains in mobile speed and capacity. The changes in technology are not science fiction nor progressing slowly over many years. The competitive advantage that drove ViaSat’s subscriber performance with the launch of ViaSat-1 five years ago no longer exists. ViaSat-2 will not drive substantial subscriber growth and ViaSat-3 will have stranded capacity.

Satellite consumer home internet – like pagers, Blackberries, pay phones and VHS players – will soon become nearly extinct in the United States, a tiny footnote in the technological landscape with products owned by a negligible fraction of households.

Like many technology businesses facing near-term obsolescence, ViaSat uses non-core products and misleading reporting metrics to disguise its doomed principal business. One particular aggressive tactic has been to use classic telecom gimmicks to inflate average revenue per user (ARPU). For the past 3 years, ViaSat has been jamming customers with commoditized add-ons like VoIP for $29.99/mo., “priority access” customer support for $5.99/mo., and anti-virus for $2.99/mo. These temporary ARPU contributions will erode under competitive pressure, just like charging for caller ID, voicemail, and call-waiting did for legacy wireline carriers. ARPU forecasts across the Street do not properly account for the high level of non-bandwidth revenues that are unsustainable in a competitive environment. When ARPU inevitably declines, so will EBITDA estimates and DCF-driven price targets.

To add insult to injury, while ViaSat waits 9 more months for its next satellite to be operational, EchoStar’s new Jupiter 2 is in the market now, poaching the few final adopters of satellite home internet. ViaSat is currently slashing prices to avoid losing a tenth of its customers before the end of the year.

Amid this deteriorating competitive position, the company is burning cash and tapping the capital markets for external funding. Since becoming a satellite services company, ViaSat has never generated positive free cash flow. The last time the company needed funding, it sold $500m of equity (14% dilutive) at a price near current trading levels. ViaSat needs the capital markets for another $1bn+ of capital over the next few years, which it will then invest in a business – satellite consumer home broadband – that will have mostly disappeared in the United States within 5 to 10 years. The company withholds disclosures required to accurately assess the health of the consumer broadband business, downplays the unit’s eroding competitiveness, and inflates metrics used in valuation, all to retain necessary access to the capital markets.

ViaSat is not an innovative company taking share from legacy telco – it is legacy telco. Subscriber metrics will woefully underperform expectations and it won’t be long until the market realizes that satellite-based residential internet is a business in terminal secular decline. We place fair value at $35, or 50%+ downside.

I. ViaSat, Inc. (VSAT) – Investment Highlights

ARPU will not inexorably rise as forecast by the Street. It will decline. A key assumption in Wall Street models and valuations is that average revenue per user (ARPU) will continue to rise off current inflated levels.1 This view is flawed because it ignores how fragile ViaSat’s ARPU has become. After years of bandwidth constraints, 40% of ARPU is now derived from charging for commoditized equipment, non-core services, and add-ons. This weak foundation to ARPU is poorly understood by investors because of the company’s inadequate disclosures. The company’s ability to continue charging for non-core services will erode as competition continues to intensify.

  • Beginning in 2014, in the wake of a strategic mistake that left ViaSat without additional bandwidth to sell, the company began emphasizing the sale of non-bandwidth “value-added” services.
  • Commoditized offerings such as VoIP, Wi-Fi modems, anti-virus protection, and even better customer care began to increasingly drive ARPU growth – a trend that noticeably accelerated in the last twelve months (+13% in the most recent reporting period).
  • The ability to charge extra for services that are included by competitors will eventually result in margin attrition as these highly profitable extras are ultimately included in basic service. The loss of these non-core service revenues will lead to lower overall ARPU.
  • The company inflated ARPU for 3 main reasons, none of which are sustainable:

1. Without additional satellite capacity, the company has aggressively pursued a rate versus volume strategy over the past 3 years. ViaSat has systematically allowed lower-value subscribers to disconnect, while selectively retaining and targeting subscribers to whom they can upsell add-on products. This is not the strategy that will be employed when they attempt to move upmarket with ViaSat-2.2

2. EchoStar, their main satellite competitor, has also faced capacity constraints during the past 18 months. In other words, ViaSat has not had to defend its subscriber base against EchoStar and has been able to get away with uncompetitive pricing actions. That changed a few months ago when EchoStar’s Jupiter 2 became fully operational.

3. The company needs cash to fund ongoing satellite development and acquisitions, and so must demonstrate near-term revenue growth to win over investors. With subscriber levels getting worse, the only way to show growth in consumer broadband was to find contrived ways to grow ARPU through non-bandwidth related products. ARPU rose +11% in the September quarter of last year, driven by the introduction of non-bandwidth products. Ten days after earnings, the company announced a $500m equity offering to help fund their next satellite program. It inflated a metric the Street relies on, without providing granularity, so that analysts would believe growth was more sustainable than it truly is. In the most recent quarter, the company tempered Street expectations for growth in consumer broadband, stating that revenues would be closer to flat due to continued subscriber losses and ARPU that only “may” compensate for continued subscriber declines.3

  • Forecasts must recognize the inevitability that ARPU will fall and the impact to valuation will be significant. 75% of forecasted EBITDA growth over the next 3 years is driven by consistent increases of a metric inflated by products and services with no enduring value. The primary valuation method employed for all satellite companies is a DCF, which in ViaSat’s case is mostly based on the terminal value given the company’s lack of free cash flow well until the next decade. Even small changes in ARPU drives a meaningful decline in valuation. This risk is not priced correctly in the stock.

Despite new, larger satellites, the company continues to lose competitive ground. Bulls focus on comparing ViaSat-2 to ViaSat-1 in formulating subscriber forecasts. The more critical analysis is how ViaSat-2 will be positioned versus terrestrial operators in 2018 and how the once favorable competitive landscape has decidedly moved against them. Whether comparing speed or capacity, satellite-based residential broadband is being rendered obsolete.

  • In 2012, ViaSat offered a compelling speed/value proposition of $50 for 12Mbps download speeds. In bandwidth economic terms, it sold speed for $4 Mbps/mo., a substantial discount to DSL ($32 Mbps/mo.) and even cable ($8 Mbps/mo.).4 Wireless was not a realistic home broadband solution.
  • In 2018, when ViaSat-2 will become operational after a year-long delay, the company will likely offer speeds of 25Mbps-50Mbps priced at $50-$75 a month – a premium speed/value proposition. Even wireless is now compelling on a speed/value basis, making it a ubiquitous, viable home broadband solution that will get dramatically better in the near future with advancements in spectral efficiency.
  • ViaSat-2’s positioning on data capacity is even worse. In 2012, the company initially capped data at 10-15GB (1/3 of average US household consumption at the time). ViaSat-2 will likely double the level at which data restrictions will apply, but average household consumption since ViaSat-1’s launch has quadrupled to 190GB per month. Cable and DSL have kept up with ease and wireless is now unlimited. ViaSat will still have to provision capacity on a per subscriber level well below average consumption.
  • The speed and capacity improvements of ViaSat-3 U.S. (the first of a planned 3-satellite constellation scheduled to launch in late 2019/2020) will not match the advancements that will have been achieved by terrestrial competitors by the time the satellite is launched. ViaSat’s upcoming satellites are not closing the gap or facilitating any move upmarket. They are evidence of the company’s increasing irrelevance in residential broadband.

The addressable market is much smaller than bulls believe and shrinking fast. Target addressable market estimates of 13-14m+ homes are built on faulty and outdated assumptions. The true figure is far smaller and contracting quickly.

  • Many analysts cite a 2016 FCC report on the number of homes that lack 25MBps download speed without recognizing that the figure fell -40% year-over-year.5
  • Broadband availability and broadband adoption are two very different things. The number of Americans who can and would be willing to pay for broadband internet is the relevant statistic, not simply the number of Americans who do not have it. Layering in socio-economic factors, housing statistics and adoption rates yields a substantially lower addressable market. The pool of economically attractive, underserved customers available to ViaSat is rapidly shrinking.
  • Bullish views on the addressability of the “low-speed” DSL market fail to account for how poorly ViaSat has historically competed against DSL, the advancements in DSL technology, and the meaningful discount at which DSL is priced. ViaSat may offer an attractive speed offering (to a rapidly dwindling number of homes) but DSL subscribers do not value speed in the same way as other subscribers – they are attracted to plans that are priced -30-40% below ViaSat’s cheapest offerings.
  • ViaSat’s subscriber acquisition costs prevent them from meaningfully discounting price to a level that would entice DSL customers.
  • Bullish shareholders fail to recognize how the erosion in ViaSat’s speeds clearly illustrates the company’s inability to add anywhere near the millions of subscribers that the company touts as its addressable market, even with multiple terabits of additional capacity. ViaSat-2 and ViaSat-3 will never meaningfully challenge the DSL market.

Reported EBITDA is overstating profitability. Reported EBITDA has increasingly captured material amounts of equipment-related lease revenue without any corresponding cash expense.

  • We conservatively estimate reported EBITDA includes $120m in consumer broadband-related equipment revenue that has no appropriate level of costs netted against it. The proper way to represent the true cash profitability of the company would be to include an adjustment for the depreciation expense related to these equipment sales. Adjusting EBITDA in this manner to arrive at “cash EBITDA” is standard practice in the telecom industry and used by equity research analysts in deriving valuation. In the case of ViaSat, it would reduce reported FY 2017 EBITDA by -18%.
  • We believe the company has deliberately structured its subscription and add-on plans in specific ways to take advantage of accounting rules to flatter its primary valuation metric, EBITDA. On an EBIT and FCF basis, it’s clear the company is not highly profitable and is significantly overvalued.

The company has never generated a decent ROIC. Bulls believe that the ROI for ViaSat-1 (touted as meeting expectations by the company but without any granular verification) and ViaSat-2 justify the worthiness of the business model. Their beliefs are flawed.

  • The target ROI on VSAT-1 was achieved because the company dramatically increased ARPU through selling commoditized products. As competitive intensity increases, charging installation fees equivalent to 3 months of service, requiring 2-year contracts, and charging extra for modems and customer service is not sustainable.
  • The project ROI on ViaSat-2, pegged conservatively by some on the Street at 16% does not include all associated ground network expenses – a figure estimated at $75-$100m by a satellite expert we spoke with and verified as missing from the $600-$650m in capex by individuals familiar with the project.
  • Satellite development costs are unlikely to ease. While management has stated the reason to take more operations in-house was done to preserve IP security, another primary goal was to quicken the payload development cycle down to just 12-18 months. This elevates capex for longer and increases the risk the company will develop capacity without accurately assessing market conditions.

Investors are cash funding increasing technology risk. ViaSat has never generated free cash flow and will require constant access to the debt and equity markets to fund $1.4bn in cash burn needs over the next four years.

  • The most recent $500m equity round priced at $69, close to current trading levels, conveniently after reporting then-record high ARPU growth and despite the CFO stating the company’s leverage position was “very low” just 9 months prior.6
  • We estimate leverage of 4.0x by the end of 2020 (assuming cash burn is funded solely from future HY bond taps – historically the mix has been 50/50 debt/equity).
  • ViaSat is burning hundreds of millions of dollars of cash annually, without any demonstrated ROIC, trying to achieve an undefined level of scale, all amid unprecedented technological change.

International Expansion Will Require Substantial Investment and Partnerships. ViaSat at its core is an engineering company; when it comes to selling the capacity, it suffers significant disadvantages.

  • U.S. retail capability was gained through the acquisition of WildBlue. As per multiple industry sources, ViaSat has no experience with retail operations in Europe. The company possesses even less in terms of infrastructure, experience, and partnerships everywhere else. This lack of global operational experience is in stark contrast to their ambitions of global satellite coverage.
  • The lack of global presence has led the company to sign a poorly structured, unfavorable agreement to gain a foothold in Europe.

II. Situation Overview

ViaSat, Inc. (VSAT)

The level of interest aviation broadband generates among investors is out-sized relative to the business unit’s contribution to total revenue (only 4%). Residential broadband is a far more important driver for the company and represents the second largest contributor to revenue and an estimated 70% of reported EBITDA. 70-80% of the capacity on the company’s upcoming satellites is devoted to residential broadband. Though the company’s disclosures have grown murkier over time, the business unit is driven by the same building blocks of any telecom model: ARPU, gross subscriber additions, and churn (the level of disconnections as expressed as a monthly average percentage of the subscriber base). Faulty assumptions and poor disclosures have led all three to be modeled far too optimistically.

ViaSat, Inc. (VSAT)

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