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OPINION

Satellite of hope

Satellite of hope
July 25, 2017
Satellite of hope

Currently, there is just nearly £20,000 in cash looking for a home. If that amount remained uninvested for 12 months then that would mean roughly an £840 loss of income. That’s the difference between a 5 per cent yield on a typical high-yield share and the 0.7 per cent interest that I get on cash – although not even that for much longer. For a fund that now distributes close to £15,000 a year that shortfall would be equivalent to 5 per cent in lost pay-out – hardly catastrophic, but worth avoiding.

True, being fully invested exposes more capital to the vagaries of stock markets where £20,000 invested might easily mean a paper loss of £5,000 if things go badly. Ostensibly, that’s far more serious. But that’s the nature of the game we’re in and – unless I have a really strong conviction – I’m not inclined to guess possible market movements. So, being fully invested and income maximising are requirements, which is right for a fund that has been around for almost 19 years; it’s at a stage where it has to do what it says on the can.

Among the candidates to fill the gap, there is a comparatively new and interesting kid on the block – mobile communications services provider Inmarsat (ISAT); interesting because it has the scale of growth opportunities not often associated with high-yield equities.

Granted, the idea that Inmarsat remains a growth stock is debatable, as its five-year record shows. In that period, revenues have changed little, and only for the worse – $1.34bn (£1.03bn) in 2016 compared with $1.41bn in 2011; ditto operating profits ($445m compared with $611m in 2011) and earnings per share ($0.54 against $0.55). However, if Inmarsat’s income statement has barely been trundling, the group’s bosses have been spending heavily in the cause of future growth. Capital spending has been far in excess of depreciation and amortisation – cumulatively $2.2bn in the five years 2012-16 compared with $1.3bn for depreciation.

That pace is to be sustained for a while, with cap-ex of about $550m this year and next. What is consuming management is the dash to roll out Inmarsat’s Global Xpress (GX) broadband network and, in particular, that part of it that will supply broadband to in-flight passenger aircraft, which goes by the initials ‘IFC’ (in-flight connectivity). The group’s GX platform is now fully operational and management aims to be generating revenues at the rate of $500m a year by the end of 2020 ($79m in 2016) from three satellites already in position. A fourth satellite was finally launched after delays in June and should enhance Inmarsat’s presence in IFC.

It’s vital the company makes a success of it. In May, chief executive Rupert Pearce said that “our performance in 2017 and 2018 will be particularly determined by our results in the IFC market”. But he also acknowledges that Inmarsat is a relatively late entrant into the market. That prompts the question: how much success should investors allow Inmarsat when it comes to valuing its shares?

Bearbull readers will know that I pay limited attention to growth prospects in valuation assessments. Usually it is sensible to assume that the future will be like the average of the recent past. That assumption is more likely to factor in a margin for safety. So, take Inmarsat’s average operating profits for the past five years – $427m – and capitalise that figure at the likely cost of capital (weighted between equity and debt). Next, adjust for the small benefits of taxes saved by Inmarsat’s debt and its spare cash, and valuation runs out remarkably close to the current share price – 807p value versus a share price of 781p.

But all that capital spending in excess of depreciation will be worth something extra, especially if it generates excess profits. So we now do a similar exercise focusing on cash flow. Here, we capitalise average free cash flow as if it were an annuity that required an 8.5 per cent interest rate (a reasonable return on investment). On top of that there is the super-charged value of the capital spending above depreciation; and it’s super-charged because it is likely to generate fat returns (the hope is that management would only authorise such cap-ex if they were confident of making plump returns on it).

Yes, those returns will fade to Inmarsat’s cost of capital and the pace at which new capital spending will come through is likely to slow. However, the long and the short of it is that for every unit of value that’s lost by capitalising free cash rather than operating profits something more is gained by valuing the cap-ex in excess of depreciation. This exercise is highly sensitive to assumptions. But even assuming excess returns fade rapidly and growth in capital spending tails off fast, there is more like £11 per share of value in the company.

That’s much more like it and inclines me to use the income fund’s spare capital for a holding in Inmarsat. Sure, I could wait to see what the first-half results – due next week – show up. But the first-quarter figures indicate there will be nothing that’s not already known. It looks very much as if the income fund is again fully invested.