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When a Minnow Swallows a Whale

Maxxwell A.R. is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors and analysts are keeping a close eye on the acquisition battle being played out between satellite imaging companies GeoEye Inc. (NASDAQ: GEOY) and DigitalGlobe Inc. (NYSE: DGI). Most of the “experts” seem to believe that smaller GeoEye is out of its league for countering a DigitalGlobe takeover bid with one of its own. According to Yemi Oshodi, managing director of mergers and acquisitions and special situations at WallachBeth Capital LLC, GeoEye is like a “minnow swallowing a whale”.

Investors have been fleeing shares of GeoEye after the failed acquisition, but some of the reasons used by analysts to justify the flight have been pretty weak. Fear has been piled onto the stock price due to expected defense budget slashing, a smaller geospatial archive compared to its competitor, and of all things, a smaller market cap. Fear can be good though. With most of the risk built into the current share price investors are presented with a gift of an entry point.

Fear #1: Defense budget cuts

In August 2010 the U.S. National Geospatial-Intelligence Agency awarded 10-year commercial satellite imagery contracts to GeoEye and DigitalGlobe for $3.8 billion and $3.5 billion, respectively, for the EnhancedView Program. The thinking goes that since GeoEye was awarded a larger sum of money, any budget reduction would affect them more than their rival.

Further reasoning proves this may be an overreaction. The difference in contracts is $300 million total or $30 million per year, which represents 8.4% of 2011 revenue. Luckily, management has grown revenues at an exospheric pace since 2008. Growth has slowed recently though, as GeoEye managed to grow revenues only 7.9% from 2010 to 2011 and expects revenue growth of only 5.4% at the top range of guidance.

While GeoEye would likely see a larger drop in defense contract revenue than its rival, it is important to remember that both companies will be affected. Assuming $300 million in budget cuts and a lousy 4% of revenue growth in 2012, GeoEye would be set back to 2011 revenue levels ($350 million) in 2013. That is certainly not as crippling as analysts make it seem and could quickly be offset when its third satellite launches in early 2013 (see below).

Fear #2: Fewer satellites in orbit

Analysts have often linked concerns about GeoEye’s archive size with its increased risk of losing government funding. Despite providing imagery for Google Earth and Google Maps, the company has a geospatial library of only 650 million square kilometers (about 3.5 Earths) compared to DigitalGlobe’s 2.2 billion square kilometer archive (about 12 Earths). That means DigitalGlobe has recorded about 80% of all high-resolution commercial imagery since 2010, which shouldn’t be a surprise given that the company has blasted off three satellites into orbit to GeoEye’s two.

But what DigitalGlobe offers in quantity, GeoEye makes up for in quality. GeoEye currently offers the most sophisticated technology of any commercial remote sensing satellite with its GeoEye-1 satellite, which has an industry best 0.41 m resolution (capable of identifying a 16-inch object on the Earth’s surface). It will be tough for the military to give up that capability.

A sizable chunk of both EnhancedView contracts went to developing a new generation of satellites. GeoEye has spent almost $700 million creating the GeoEye-2, which will have a commercial-best resolution of 0.25 m.

<img src="/media/images/user_6293/geoeyesatelliteresolution_large.PNG" />

This table shows the advancement in satellite resolution in the last 40 years. Quickbird. WorldView-1, and WorldView-2 belong to DigitalGlobe while IKONOS, GeoEye-1, and GeoEye-2 belong to GeoEye. The WorldView-3 is not pictured, but has a resolution of 0.34 m. Source: GeoEye Inc.

When launched in the first half of 2013 it will be the most sophisticated commercial satellite ever created. Furthermore, it will give GeoEye three satellites in orbit and open the company to a broader customer base by providing an additional 1 million square kilometers of coverage per day and allowing daily revisits to designated Earthly locations.

Eyeing value

To be fair, DigitalGlobe is developing the WorldView-3 satellite that is expected to have many bells and whistles. It will offer an impressive range of capabilities and up, err, down, the resolution war to 0.31 m – second best in the industry. It will also give DigitalGlobe four satellites to GeoEye’s three. But looking at past performance, does fleet size really matter?

DigitalGlobe has maintained its one satellite lead since October 2009 when it launched WorldView-2. In that same time span the company has grown shareholder’s equity by 28.9% compared to GeoEye’s 43.7%. In terms of equity – what matters during acquisitions – GeoEye is actually the larger company ($507.3 million vs. $487.4 million). The following table shows that management at GeoEye is nearly 3.6x more efficient in utilizing its expanding archive and simply better at creating value:

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>DigitalGlobe</strong></p> </td> <td> <p><strong>GeoEye</strong></p> </td> </tr> <tr> <td> <p><strong>Geospatial archive</strong></p> </td> <td> <p>2.2 billion square km</p> </td> <td> <p>650 million square km</p> </td> </tr> <tr> <td> <p><strong>Square km per 2011 revenue</strong></p> </td> <td> <p>6.48 square km/$</p> </td> <td> <p>1.82 square km/$</p> </td> </tr> <tr> <td> <p><strong>EPS (ttm)</strong></p> </td> <td> <p>($0.50)</p> </td> <td> <p>$2.20</p> </td> </tr> <tr> <td> <p><strong>1Q12 revenue</strong></p> </td> <td> <p>$87.00 million</p> </td> <td> <p>$89.28 million</p> </td> </tr> <tr> <td> <p><strong>Book value</strong></p> </td> <td> <p>$10.59</p> </td> <td> <p>$23.46</p> </td> </tr> </tbody> </table>

Data compiled from Google Finance and DigitalGlobe and GeoEye websites.

Foolish bottom line

I cannot tell you what happens when a minnow swallows a whale, but I can say that GeoEye is not a minnow. The company’s current market valuation coupled with management’s ability to create value leads me to believe that analyst fears surrounding the company are overblown. Beating analysts is nothing new to GeoEye, which has humbled Wall Street’s EPS estimates in four of the last five quarters and smashed revenue expectations in the prior two quarters.

There are always unknowns after failed acquisitions. But with a fair book value of $23.46 per share (a 23.5% premium to $19 per share) it looks clear that a lot of the risk has already been priced into shares. If a merger happens – in any order – GeoEye shareholders stand to profit. If both companies decide to remain on their independent paths GeoEye shareholders have plenty of growth to look forward to with GeoEye-2, even if they lose revenue to budget cuts.

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