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New Moon
New Moon
Articles (35)  | Author's Website |

Large Discount to Intrinsic Value

If Loral's major shareholder closes the gap between the share price and intrinsic value, the upside could be impressive

Loral’s share price has dropped more than 50% since the beginning of 2015 while its major assets have been performing well. The stock is currently at 30% to 50% discount to a conservatively estimated fair value. Removing such a discount would result in more than 40% shareholder return.

Loral’s controlling shareholder has tried several times to remove the discount in the past and is still trying hard. The chances are that it will succeed sooner or later.

Who is Loral?

Loral Space & Communications (NASDAQ:LORL) is a U.S.-based holding company with only one major asset, a 62.8% stake in Telesat Holdings. Telesat is the fourth-largest satellite operator globally and the largest in Canada. It offers broad satellite services to more than 400 customers from its fleet of 15 satellites and has two satellites under construction. Telesat’s blue-chip customers include Bell TV, Shaw Direct, EchoStar/DISH Network (NASDAQ:SATS)(NASDAQ:DISH), AMC Networks (NASDAQ:AMCX), Bell Media, Canadian Broadcasting Corporation and HBO.

Almost 80% of Telesat’s revenue is from Canada and the U.S. The remaining 20% is from Latin America, EMEA and Asia. North America customer service contracts are typically multiyear in duration. The current contracted revenue backlog is CAD 4.8 billion against 2015 revenue of close to CAD 1 billion.

Telesat Holdings is the combination of Telesat Canada and what used to be Loral Skynet. Telesat Canada was formed in 1969 as a government entity and launched the world’s first domestic commercial satellite in geostationary orbit in 1972. Since then, Telesat Canada has provided satellite services across Canada. In the 1990s Telesat Canada was divested by the Canadian government, merged with some other entities and continued as Telesat Canada as part of BCE.

Loral Skynet was a subsidiary of Loral Space & Communications. It traces its history to two of the originating businesses in U.S. satellite communications with more than 40 years of experience: AT&T Skynet and Orio Satellite Corporation. In 2007, Loral and the Public Sector Pension Investment Board (PSP Investments) acquired Telesat Canada and certain assets from BCE for CAD 3.25 billion. Loral then transferred substantially all of the assets in its subsidiary, Loral Skynet, to Telesat Holdings.

Loral holds 62.8% of the economic interests and 32.7% voting power of Telesat Holdings, and PSP Investments indirectly holds 35.8% of the economic interests and 67.3% voting power.

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Mark Rochesky’s MHR Fund Management LLC owns 38% of Loral. The stake accounts for about 20% of the fund. Rochesky is a protégé of Carl Icahn (Trades, Portfolio) and an activist investor with very concentrated positions. MHR invested in Loral’s junk bonds when Loral got into trouble in 2001. After Loral went to bankruptcy in 2003, MHR ended up with a 36% stake in Loral through a debt-to-equity swap (Source).

MHR has been having significant influence on Loral ever since. In 2007, Loral first acquired Telesat Canada. In 2012, Loral sold its satellite-manufacturing business for $1 billion and distributed the proceeds to Loral shareholders as special dividends after the sale. In July 2015, Loral gave Telesat a notice requiring Telesat to conduct an IPO (Telesat 20-F 2015).

Leon Cooperman (Trades, Portfolio) owns 5% of Loral and has been adding steadily.

What is interesting

Loral’s stock has dropped more than 50% since the beginning of 2015.

But Telesat’s operations seem to be not only fine but improving. At the end of 2015, Loral also launched a new satellite that should improve its earnings even more.

The decline in the stock's price probably was due to the significant depreciation of the Canadian dollar in 2015 as a result of the collapse of oil prices. The stronger U.S. dollar inflated Loral’s largely U.S. dollar-denominated debt against its assets and therefore reduced the equity value by about 25% since the beginning of 2015. However, Loral’s share price dropped more than 50% and currently trades at a 27% discount to stake in Telesat Holdings valued at a modest 8x EV/EBITDA. The question is whether Loral’s holding company discount will be removed.

Loral’s 38% shareholder MHR has tried several times to realize the value of Loral and Telesat. In 2011, Loral and Telesat’s other owner, PCP Investments, jointly tried to sell Telesat for $7 billion. Then in 2014, MHR was close to selling Loral to PCP Investments and another Canadian pension fund but ultimately rejected the proposed price of more than $80 a share (Source). Recently, MHR has been pushing Telesat for an IPO (Telesat’s 2015 form 20-F). Whatever the result this time, it is certain that MHR will not stop trying until Loral gets the full recognition of its value. Noticeably, MHR added to its position in Loral in March after several years of inactivity.

One thing to note, Loral’s value is sensitive to the U.S. dollar/Canadian dollar exchange rate due to Telesat’s large amount of U.S. dollar-denominated debt of $2.5 billion. As the Canadian dollar depreciates, the debt burden increases, reducing equity value of a financially highly levered company.

But if the Canadian dollar appreciates, the positive effect on equity value is material. The following table has the sensitivity of Lorel’s discount to intrinsic value with Telesat valued at 8x EV/EBITDA. Everything else being equal, the upside of Loral’s stock from eliminating Loral’s holding company discount would increase from about 30% at 1.3 U.S. dollar/Canadian dollar exchange rate to 111% at 1 U.S. dollar/Canadian dollar exchange rate. At the same time, the leverage measured by net debt/EBITDA would decrease from about 4x to 3x, significantly reducing credit risk.

Where is the U.S. dollar/Canadian dollar heading? With the oil price going up again, there could be more upside than downside for the Canadian dollar. But admittedly this is a double-edged sword.

What are the worries?

Although the satellite communication business has high margins due to high entry barrier, the business has substantial risks associated with technology, asset concentration and customer concentration. For example, the newly constructed satellites have much higher capacity. With new satellites replacing the old ones, there could be more competition in pricing due to extra available capacities. Another risk is the loss of assets. Telesat has 15 satellites. Losing any one could mean material reduction in Telesat’s revenue because insurance will not cover loss of revenues. Finally, Telesat’s five customers account for 58% of Telesat’s revenue and 81% of backlog. These customers may have material influence on contract pricing.

Telesat has a high debt load, which is typical of a satellite operator. Although Telesat has relatively smaller leverage compared to its global competitors, a close to 4x net debt/EBITDA still could bring big trouble at bad times. To make the leverage problem worse, the majority of the debt is denominated by the U.S. dollar. The significant depreciation of the Canadian dollar would cause debt to go up and therefore shrink equity value.

In fact, Loral’s price started to fall from the end of 2014, coinciding with material depreciation of the Canadian dollar.

Holding company discount may not be realized within the short term even if the shareholders want to unlock value. MHR certainly has tried several times, but Loral remained as essentially 62.8% of Telesat at a discount.

Valuation

Telesat’s major satellite operators sell at 8x to 11x EV/EBITDA. Valuing Telesat at 8x EBITDA with U.S. dollar/Canadian dollar at 1.27 would imply Loral shares at 27% discount to its stake in Telesat. It looks like the stock has limited downside from here in the absence of a bad satellite market. The risk is much more skewed to the upside.

There are two sources of major risks that can be hedged out if one chooses. The first is the exchange risk, which could be hedged through shorting the Canadian dollar or even oil. The second is industry risk, which could be hedged through more highly levered global peers such as Inmarsat (ISAT), Intelsat (I) and Eutelsat (ETL).

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