Description

Global Eagle Entertainment has been written up on VIC before. In this write-up I will offer a different angle to look at the business - partly in light of recent developments. The company has just been through a series of traumatic events, including a shockingly expensive internal control probe orchestrated by E&Y. After a year of delayed financials, the released numbers failed to appease investors. The stock was sold off violently, and it is now trading at a deep discount to its sum-of-the-parts value. Investors have the right reasons to hate the stock, but I believe the magnitude of the company’s liquidity risk is overblown, and long term solvency risk is not justified either. Critically, the industry’s business model has largely changed and investors underappreciate the resulting improvement in business quality. I expect multiple catalysts within the next 12 months to revalue the stock.

History

ENT started as a SPAC in May 2011. The SPAC was sponsored by former Hollywood executives Harry Sloan (former Chairman of Lionsgate and MGM) and Jeff Sagansky (former President of Tri-Star, Sony and CBS). With an inception in the entertainment world, the company of course has to be located in Los Angeles. Once in a while SPACs acquire good businesses at cheap multiples, but unfortunately this is just the typical SPAC case here. In 2013, the company acquired 100% of ROW 44 (inflight connectivity, or IFC) and 86% of Advanced Inflight Alliance (inflight entertainment, or IFE). These two transactions were the formation transactions of the SPAC and provided the very genes of the company today.  

Advanced Inflight Alliance (AIA) was listed on Frankfurt exchange as DVN1 GR when the company acquired the 86% shares. The remaining minority shares were subsequently squeezed out and the company now owns 100%. AIA acquires rights to play entertainment content (movies, etc) on long distance flights. In essence, it is a more operation intensive version of cable television operator on flights, and airlines are like the cable carriers. It does not produce content by itself, and in a world where good content gets more expensive investors are rightly worried about how good the business is. But, it pretty much dominates the market and is the go-to provider for airlines.

ROW 44 was a privately owned business that provides inflight WIFI services for airlines. The company was founded in 2004 and obtained line fit with Southwest Airlines in 2010. Hughes Network Systems has been the long term satellite bandwidth provider.

Notably, Par Capital was a major shareholder in both ROW 44 and AIA and rolled their equity into ENT - and now they own 32% of ENT. Ed Shapiro - formerly with Par before he decided to join the Board of United Airlines - became Chairman of ENT and continues to oversee the company today. Par Capital has probably been one of the most successful airline investors over the past twenty years and their vote of confidence spoke a ton about the business. Importantly, many investors speculated that Par would eventually need an exit - likely through an M&A with a strategic buyer. Sadly, this became a “lesson learned” rather than a success story - with a series of events quickly unfolded and the house of cards collapsed.

The company made a few small acquisitions which I will not discuss here. Then in May 2016, it acquired Emerging Markets Communications (EMC) for $550MM, and assumed $371MM of debt from the acquisition. The following was advertised in the original press release:

“EMC is projected to reach $190-200 million in 2016 revenue and $55-65 million in Adjusted EBITDA in 2016. GEE projects annual synergies of at least $40 million resulting from removing overlap in existing network infrastructure, reduced bandwidth costs, lower development expenses and integrating internal operations. GEE expects to achieve annual synergies of approximately $15 million in 2017 and reach $40 million run-rate by 2019. Costs to achieve the synergies are expected to range from $4 to $5 million over the next 18-24 months.”

Of course none of the above happened. EMC lost some revenues and cost synergies got pushed out, partly due to the events that followed. At various points the company was also rumored to attempt to acquire the remaining 51% interest in Wireless Maritime Services (WMS), a minority interest that came along with EMC. But the acquisition did not come into fruit - luckily for the shareholders.

In November 2016, HNA Group announced it would inject equity into ENT at $11/share and it would form a Chinese JV with the company. The JV would be the exclusive provider of IFC for HNA. However, instead of trading towards the deal price, the stock quickly began its long slide. A few months later, the transaction was terminated due to difficulties with CFIUS. When the termination was ultimately announced, the stock was trading at ~$3.00 zip code.

In January 2017, in addition to the EMC acquisition, ENT’s former CEO bought a 20 year old inclined-orbit satellite - conspicuously named Eagle-1 - for $29MM. The satellite world has been going through rapid technology upgrades and bandwidth expansions, so no sensible investor would want to own a satellite. But paying $29MM for a satellite that was about to fall from orbit is a whole other level of incompetence. Decisions like this tell you how critical it was to institute a regime change - and it is discussed in the thesis section below.

At the time of annual audits of 2017 financials, auditors from E&Y became concerned about the weak internal controls the company had in place - especially after the EMC transaction. So they decided to embark on a full scale investigation into the company’s accounting practices. As we have learned from other cases, accounting investigations are never easy, and management are almost always too optimistic about the timeline. What happened in this case, however, still surprised me. The auditing costed the company $63MM (over 10% of the company’s revenues), and ultimately found nothing except for weak internal controls which were already disclosed at the outset of the investigation. No restatement was needed, and no fraud was discovered. The investigation dragged on for almost a year and the Board decided that E&Y was pushing too far. They fired E&Y - or more precisely, retained E&Y for 2016 10K, but hired KPMG for the subsequent audits. The company finally became current with all its financials in early 2018. During the interim, management renegotiated multiple times with debt holders and as I will discuss below, these serve as important data points for the company’s problems.

It is important to note that the company is now current with all its financials, and we are not underwriting any black box accounting restatement risk as part of the investment thesis.

Investment Thesis

With regime change, ENT is a business at inflection. The company experienced several traumatic events over the past two years largely because of poor decisions made by prior management. These decisions include: 1) levered buyout of a mediocre business (EMC) at an expensive multiple ($550MM for a flattish business with $55MM to $65MM of adjusted EBITDA); 2) failure to integrate the pile of acquired assets over the years - the company is a poorly integrated rollup of rollups; 3) acquired an aging satellite for $29MM in 2017 in a world where satellite tech depreciates at amazing speed. The common thread of all these decisions was capital allocation - stupendous empire building with almost zero attention to operations. The Board made belated, but much needed decision in 2017 to fire the former CEO Dave Davis (and alas, I think investors should continue to track the companies he is going to run, if any, for short ideas). A whole suite of new management was hired to turnaround the ship: CEO Jeff Leddy, a satellite expert who used to run Hughes Communications; CFO Paul Rainey; and Chief Accounting Officer Sarlina See. The reinforcement of the Finance function was critical as the company was deeply mired in the above mentioned accounting investigation.

I think a few decisions made by the then incoming management team (and the Board) provided evidence of their execution capability: 1) Negotiated with airlines and pioneered the change in business model in the industry (discussed below); 2) Fired E&Y after the auditing firm intentionally prolonged the accounting probe. It is very risky to fire the incumbent auditor in an existing probe, but the Board had the audacity to do just that - and it was subsequently proved as the correct decision. 3) Delivered all financials on time and avoided a delisting from NASDAQ. 4) Won several new businesses when the market decided the business’ problem to be terminal. I believe the above evidence speaks volumes about management veracity and gives me comfort that things will start to turnaround from here.

As dust settles from the accounting probe, management is now focused on delivering 10% to 15% cost reduction. The cost reduction is expected to improve EBITDA from $67MM in 2017E to ~$90MM in 2018E. I acknowledge that it is the key to underwrite this investment - is it a 10X levered investment or 6.7X levered (or better) investment? I believe it is the latter. The reasons are: 1) As discussed, the prior management paid almost no attention to integration. 2017 saw recurring fire drills with the accounting investigation, contract renegotiations and credit alleviations - and management did not have time and resources to realize any cost synergies. 2) Revenue contraction has bottomed in 2017 and the already announced contract wins will improve revenues in 2018 and beyond. Two airline bankruptcies (Alitalia being one of them) and annualized effect of the loss of American Airlines in 2016 (on the content side) dented the 2017 revenues and comps will improve from there.

The market underappreiciates the change in business model. When I looked at the business two years ago, I was not sure if it was a capex treadmill like most telecom businesses. However, in 2017, the industry went through a subtle yet profound change. Airlines now pay for the upfront equipment cost - and not the IFC providers. It made sense as airlines have much lower cost of capital than ENTs of the world. GOGO is the only company that has not explicitly engaged in the change, but in the most recent earnings update, they almost embedded the shift under the guise of an accounting policy change:

“In our commercial aviation segments, under our contracts with airlines, aircraft operate under either a turnkey or airline-directed commercial arrangement. Starting in 2018, we expect the mix of aircraft operating under the airline-directed model to be significantly higher than in prior years due to the transition of certain existing airlines from the turnkey model to the airline-directed model and new aircraft coming online under the airline-directed model. Our 2018 guidance reflects this business model shift.”

So the industry now operates under a capital lighter - if not capital lite - model. These businesses are much more akin to a service business model. Are these suddenly good businesses? I do not think so. But I believe the change resolves the long term existential question and therefore qualifies the idea for a discussion under the value investing framework.

Concerns about liquidity risk is overblown. When the company provided its business update in February 2018, investors stared at the cash flow waterfall and calculated that the company will very unlikely have sufficient liquidity in 2018. Mathematically, with $60MM of adjusted EBITDA, $48MM of annual interest payments, $30MM of capex - the company will be $18MM short in 2018. It is a legitimate concern. I will attempt to argue the contrary in two ways - one quantitative way and one qualitative way.

The quantitative way: 1) The company has small pieces of real estate that can do sale-leaseback transactions; 2) it has small pieces of non-core assets including an on-the-ground content distribution business that can be sold. The above two will generate a couple of millions. 3) working capital improvements. For example, days sales outstanding was 68 days versus GOGO’s 50 days and VSAT’s 56 days. 4) With cost cutting we should expect the business generate more than $60MM of EBITDA, if not $90MM. 5) Although the company does not intend to, but selling WMS is always an option. I believe the company has enough levers to pull to resolve the liquidity shortfall.

The qualitative way: 1) The industry operates under long term contracts. Airlines look at their suppliers closely and will very unlikely sign up new contracts if they believe their business partner will have an imminent liquidity problem. Also, compared with equity investors, airlines have a very significant information advantage. The recently signed deals with Finnair, All Nippon Airlines, Air France, KLM, Gulf Air and China Airlines indicate customers were not as concerned as equity holders about the liquidity shortfall. 2) KPMG was willing to sign off the company’s 2018 operating budget and continue to prepare the financials under the going concern assumption. Given how intense the audit was and how alerted KPMG should be (E&Y was kicked out), their opinion carries a real weight versus normal audits. 3) The company negotiated with the senior creditors in 2017 and each covenant relief came in at lower costs. To witness: the May 2017 relief cost $5.6MM. The June 2017 relief cost $3.9MM. The September and October relieves cost $1.4MM each. Credit investors have an information advantage versus equity holders, so I believe the signaling means something.

Also, most of the debt are owned by senior creditors. These people tend to work with the business when problems arise - they typically do not go aggressive against the company and attempt to foreclose the business unless it is the last resort. This particular group of debt owners have been quite lenient, as evidenced by the repeated covenant relief when the outcome of the audit still remained unknown. I do not think they will suddenly become more aggressive when the biggest risks (accounting and delisting risk) are now behind. Lastly, it is also important to note that the debts are currently all long dated - and I have rarely seen outright bankruptcies in normal market conditions when time still stand beside the equity owners.

Both the connectivity and content businesses have highly visible, long dated contracts, and the end market is still growing. The connectivity equipment (modems, etc) is tailored to each provider’s ground network (not the satellites), and therefore in order to switch out the provider, airlines have to ground the plane for a couple of days and reinstall new equipment. Losing a few days of operations is very costly for the airline business. Although the North American market is maturing, there are still sizable opportunities in Europe and Asia. Despite the fallout of the HNA JV, the company is still actively working with HNA and should eventually figure out the right structure to serve them. The content business, on the other hand, operates mostly on long distance flights. Media rights across regions are extremely tricky and in the near future it is unlikely to see people stream netflix over the ocean. Absent of idiosyncratic events, the business is expected to grow 5% a year, in line with the growth of dual aisle, wide body airplanes.

Par Capital’s ownership provides some comfort about governance. Usually governance is argued as a risk mitigation factor, but I believe in this case it should be an active part of the thesis - given the multitude of problems the company has experienced. But, governance and quality of the Board is also very hard to diligence. In this case, I would argue, that it was almost the failure of governance that woke up the Board, and we have observed a series of decisive actions that demonstrated the efficacy of the renewed Board (renewed in terms of Board oversight, not people). The decision to fire Dave Davis and the old guards was arguably late, but very swift. The decision to fire E&Y was very bold, but proved to be correct and timely. The new management team has so far executed at least in line, if not exceeded, expectations - so the Board hired the right people in a relatively short time, when things were still very murky. Ultimately, Ed Shapiro has been a successful airline investor over his career and he should provide the necessary guidance for this company if needed.

The company had a recent, under-advertised contract win with Air France. The following is from the recent business update call:

“(William Blair Analyst) Also, nice work on the potential new European customer for greater than 125 aircraft. Josh, as you know, you have been involved in trials with a particular European customer since 2014 and I was wondering if this potential big win is for a different customer.

(Joshua Marks): All I'm going to say on that is our business model, our partnership model with airlines allows airlines to control the onboard product. It allows airlines to define how they want to roll it out. And in this case, the airline will announce it when the airline is ready to. We're proud of what we accomplished. We have a lot of work to do to roll the system out in a timely way. As we said, the POs are in so the process can get started. We're thrilled about where we are and we're looking forward to the airline making that announcement.”

The answer was very unclear and the entire comment was buried in a mountain of issues - given it was the first conference call after the company became current with its financials. Multiple channel checks indicated that the win is with Air France. Our understanding is that Air France controls the press release and ENT is not at liberty to disclose the name. However, Air France should eventually make an announcement over the next few weeks in line with historical norms. What if they don’t? In that case we still have 125 planes which is a ~15% increase over their exiting install base, and it will eventually be reflected in the numbers.

Capital Structure and SOTP Valuation

The equity has the following senior claims on top:

• $78MM of senior secured revolving credit facility, due January 2022. Interest rate is base rate plus 6.5%.
• $491MM senior secured term loan facility, due January 2023. Interest rate is base rate plus 6.5%. The loan is currently trading at 101c.
• $82.5MM convertible senior notes due 2035. Coupon rate is 2.75%. Conversion price is $18.55 - so it is deeply busted. The convert currently trades at 61 cents on the dollar. It does have an embedded put option effective Feb 2022 at 100c. Yield to next put is ~16%. Conceptually it is interesting. However, the convert is a small piece sandwiched between the seniors and the equity - to argue that you want to own the convert instead of the equity, you are either 1) precisely sure about the valuation (that the fulcrum piece is the convert) - which I believe is a very hard thing to do for an evolving business with no imminent threats of bankruptcy (a point that I argued above in the thesis section but you can disagree); or 2) making an intellectual concession about the analysis that you want to own a safer security - a concession that I will not make. Be aware that there is no immediate mechanism for the convert to trade back to par - but equity does not have this problem. Also, for what it is worth we have also spoken with a few debt investors and the unanimous response was the convert was too small to justify any work. But investors can make their own decisions.
• There are some other smaller pieces of debt totaling $2.7MM.
• As of 12/31/2017, the company had $50.8MM of cash.
• That gives you gross debt of $654MM and net debt of $603MM as of 12/31/2017.
• There were warrants from the SPAC era, but they are now either cleaned up or expired - so none left.

I will use 3Q17 annualized revenues to attempt the SOTP valuation. 3Q17 was likely the trough of the business and therefore provides the most conservative going-in assumption for this investment versus LTM numbers. The public comps generally trade at very high multiples (GOGO, VSAT). I think these comps - especially GOGO - are overvalued and I do not think ENT should or will trade at those valuations. Then the question is - in today’s environment what kind of multiple should investor pay for such a mediocre business? I will discuss by segment:

• The Media and Content business generated $285MM of annualized revenues and 26% gross margin. The business is expected to grow at an unimpressive rate of 5% a year (discussed above). Also as mentioned above, the contracts are long term and the revenue stream is quite durable. Let us say it is worth 1X revenues (if they can deliver ~10% EBITDA margin over the long run - which I think they will - this valuation implies 10X EBITDA). For a business that is not highly capital intensive, I consider it a fair multiple. At 1X revenues, it is worth $285MM.
• EMC generated $175MM of revenues and ~20% gross margin. The 20% gross margin will likely improve as: 1) some of the one-off investments the company made to improve service levels and reduce churn will run off and 2) some reversion to mean - only two quarters ago the gross margin was ~25%. Let us say they can ultimately deliver 15% EBITDA - and we are willing to pay 8X EBITDA. The business is worth $215MM. The $215MM plus the $155MM book value of WMS/Santander equals $370MM. Remember the company paid $550MM two years ago and we are essentially assuming a ~33% haircut. Also remember that when Abry sold the business to ENT, it was carrying $371MM of debt - and Abry considered the business in-the-money. So our assumption that these holdings are worth $370MM is unlikely aggressive.
• The non-EMC connectivity business generated $140MM of revenues and ~31% gross margin. This is mostly Southwest - who recently renewed the contract. The effect of two airline bankruptcies have been taken out from the numbers. Their contract with Air France will increase their install base by ~15%. Let us say it is worth 1.2X revenues, or at 12X EBITDA at 10% EBITDA margin (the realized EBITDA margin is likely much higher). At 1.2X the segment is worth $168MM.
• The above businesses total ~$824MM.
• And then we have $152MM of federal NOLs as of 2016 (and probably more than $250MM once the 2017 10K is released). I am assigning zero value to the NOLs. Valuing NOLs can be tricky as observed by the busted NOL shells such as WMIH.
• There are unlikely any significant off balance sheet issues as the company only recently emerged from an audit that costed $63MM.
• Taking out $603MM of net debt it gives us an equity value of $221MM. With 90.8MM shares, it is about $2.42/share, or 78% upside from the current stock price.

Valuation can be tricky for levered businesses. However, I believe the above assumptions are sufficiently conservative and we have a very good margin of safety.

Risks

• As a levered equity, investors face heightened volatility and mark-to-market risks. You have to size appropriately.
• Customer concentration - Southwest is >20% of revenues. However, the contract was recently expanded - indicating the risk is mitigated in the near term.  
• The business may face near term margin pressure as satellite costs deflates and customers demand more capacity under the same price. The company has opted out of satellite ownership and is in the process of structuring shorter leases to take advantage of tech deflation. But, this will be a process.
• The connectivity business is getting more competitive in recent years as satellite providers are stepping in to seek direct contracts with customers. This is most evidenced by VSAT. However, such changes mostly impacts new businesses. The fact that the company is still winning new contracts indicates the industry structure is not as busted as investors may have assumed. Also, the company was able to retain Southwest - indicating there is no near term pressure to the business.
• There will be few strategic acquirers for the assets as a whole. The collection of assets make sense, but it is hard to see a strategic wants to own all the pieces. If there is a transaction, it is most likely done through a piecemeal approach - or to a private equity buyer.
• Rising cost of debt in a rising rate environment - the senior debt are all floaters. Every 1% change in interest rate would mean $5.7MM of additional interest costs. But, as some of the operational issues from the transition years get resolved and pro forma leverage improve, it is conceivable that senior debt holders will be willing to lower the cost.
• The company is implementing Oracle and has not finished yet. Accounting system renewals always carry some risks - but it is something we have to underwrite.
• There may be some selling pressures from two sources: 1) Abry Partners (who owns 9.6MM shares through EMC) has begun selling off their shares. The shares are owned by Abry Partners VII, a 2011 vintage vehicle. That said, so far they have been selling quite diligently with few shares executed. I do not know what their MO will be going forward and it could be a persistent overhang for the stock. 2) Russell 2000 index rebalance in May/June. The company has been a proud member of Russell 2000, but the precipitous fall of market cap from $550MM in 2016 to $123MM today would almost certainly mean that they will be kicked out of the club.

Catalyst

• Issue a press release of the Air France win.
• Issue 2017 10K and hold a business update call.
• Sell non-core assets / sale-leaseback of real estate.