Avanti Communications Group — Update 2 March 2017

Avanti announced the success of the consent solicitation process on 6 January 2017, with over 90% of the bondholders having accepted the improved terms offered to them. The complex refinancing completed on 27 January and the package provides the company with $242m of additional funding headroom. It allows Avanti to continue its strategic build of a satellite network and related infrastructure. With capex and working capital requirements now covered, the two satellites due to be launched later this year can be completed. HYLAS 4 is a high throughput Ka-band satellite costing around $300m with over 28GHz of capacity that will more than double Avanti’s revenue potential and is now expected to be launched in Q317. HYLAS 3 is a smaller, 4GHz Ka-band package likely to be launched on the European Space Agency’s (ESA) EDRS-C satellite later in 2017 although this is not yet certain.

The refinancing structure is summarised below:

Interest accrued on the existing bonds before the refinancing completed of c $23m is effectively converted into additional bonds at par, so the effective nominal restructured is $708m.

We discuss the refinancing package in more detail at the end of the note, but the main elements affecting equity investors are:

Following the refinancing the Avanti board has been restructured and the bondholders will be given representation on the board via the nomination of three directors and the selection of two non-executive directors. The existing Chairman, CEO and CTO are retained and a new non-executive director, Richard Mastoloni was announced alongside the refinancing proposal. He was previously involved as an NED in the successful refinancing of Satelites de Mexicanos.

In terms of the net present value (NPV) of future cash flows transferred to bondholders from equity holders, this is summarised in Exhibit 2. We assume all PIK opportunities are utilised. We estimate it as $278.6m made up of incremental interest payments and additional bond redemptions. This is partially offset by the benefit from the deferral of the existing $708m bond redemption from October 2019 to October 2023 of $186m, which leaves the NPV transferred to bondholders at $92.3m.

The uncertainty caused by the strategic review during the first half of FY17 was reflected in performance. The highlights of the first half results released on 28 February are shown below:

The H117 results were released on 28 February and confirmed previous management comments. While revenue growth was limited there was a significant currency headwind. On a constant currency basis the improvement would have been 11.9%. Cost of sales remained reasonably consistent with H216, although higher than H116 due to increased kit costs and subcontract costs on government contracts. FX reduced employee costs (which are largely in sterling) enhancing the cost control measures. This widened the EBITDA loss and loss before tax.

The refinancing also increases gross cash balances to $62m as of February 2017 following the receipt of the bond issue receipts, partially offset by capex on HYLAS 4.

HYLAS 2-B was operational for only a few weeks during H117 and will add a more significant contribution in H217, albeit at a lower level of utilisation than the current satellites. Management also notes an apparent improvement in pipeline conversion since the refinancing was announced.

Guidance from the company reflects the anticipated improvements in satellite fill rates as well as the addition of new capacities and the ramp up of framework contracts. The improvement should start to be reflected in improved H217 revenues. The implied momentum combined with the overall depressed nature of FY17 sales due to the now alleviated uncertainty, we feel should mean the medium-term 35-40% sales growth target may be exceeded in FY18. We assume a successful launch of HYLAS 4 which should make an incremental initial contribution in H218, and HYLAS 2-B should increase its fill rate and will make a full year contribution.

Progression will be supported by a number of major contract wins, many of which are framework agreements not represented in the current order backlog.

EE continues to widely promote Avanti’s technology being supplied in the $29m contract supporting the extension of coverage for the mobile element of the UK’s Emergency Service Network. It is the world’s largest 4G mobile satellite backhaul contract that includes over 1,000 towers and first responder vehicles. Further to this success Avanti has continued to announce further key contract wins in the current financial year, especially in the carrier services and government segments.

Also in Carrier, Avanti has contracts now to deploy 2,500 satellite backhauled wi-fi hotspots in Africa in its Every Child Online project.  This is expected to grow to tens of thousands of sites, and could provide an interesting revenue model for Avanti through the products ability to deliver revenue directly from the end consumer to Avanti through an automated payment portal already roll out ins Kenya and Tanzania

Following the refinancing agreement, Avanti has provided a revised series of performance indicators for the medium term, which have significant impact on forecast revenues, earnings and cash flows. The main elements of revised guidance are:

It should be noted that management has indicated options for HYLAS 3 are being considered as the launch has already been severely delayed. HYLAS 3 is a 4GHz payload package on the larger ESA EDRS 2-C satellite, and while launch is still slated for later this year, it is not certain due to issues on the main satellite. The HYLAS 2-B capacity essentially compensated Avanti’s model for the absence of the capacity from HYLAS 3, and we suspect the options being considered may include a sale of the entire package or negotiation of spectrum rights usage by third parties.

Essentially the Avanti model is unchanged, although the funding structure has altered significantly. As previously, the focus for management following the refinancing has to be on completing the network now funding is in place and filling capacity in order to grow revenues against the predominantly fixed cost operating cost base. The increase in free cash flow that the growing revenue should generate will coincide with the sharp fall in capex once the new satellites are launched. However, the interest burden increases substantially, deferring free cash flow break even, which is further delayed by the reduced revenue growth expectations. With 10% more shares in issue, unsurprisingly equity valuation estimates are reduced, with increased gearing to future cash generation performance.

We continue to believe that a DCF methodology is appropriate for Avanti’s business model, although the revised terms of the high interest bonds and the PIK process are clearly dilutive factors for equity valuations.

We have revised our DCF to reflect only the existing (HYLAS 1, HYLAS 2 and HYLAS 2-B) and planned satellite capacities (HYLAS 3 & 4). However, we are now assuming no revenues from the HYLAS 3 package, although this should provide some value for shareholders so we have incorporated an estimated cost of construction value of $60m, although the current insurance value would include launch costs increasing the value to around $90-100m.

We have also adjusted terminal cash flow for the finite lives of HYLAS 1 and HYLAS 2 at fifteen years by eliminating their revenue contributions from the terminal value. Again, the contraction of the DCF to more closely reflect the finite service of the existing fleet life represents a cautious view of the longer-term potential for business development. It remains entirely plausible that Avanti will extend its network further in the future, replacing existing satellites with higher capacity models, providing an increase in terminal value.

Due to the very low equity valuation the calculated WACC of 11.3% is close to the weighted average coupon of the gross debt. Our DCF calculated on the above basis returns a value of 109p per share. The reduction of value compared to our previous values is made up of four elements: transfer of value to the bondholders (overstated in our DCF by the assumption all debt is immediately redeemable), 10% increase in share count, lower revenue guidance, and the curtailment of the DCF to existing and immediately planned fleet. The sensitivity of our DCF to WACC and terminal growth is shown in the table below, with the closest value to our WACC assumption highlighted.

The risks to the equity valuation remain broadly similar to those indicated a year ago, although clearly the increased role of the bondholders and lower forecasts remove significant value potential for equity holders. The refinancing largely removes an element of risk related to the financing of the build out of the space network, but the risk from slower than expected commercial development remains. Issues such as a technical or catastrophic failure are largely covered by insurance.

In respect of the bond refinancing Avanti is subject to a soft covenant for the duration of FY18. We suspect this relates to commercial performance, which could lead to further equity value diminution.

We have altered our revenue assumptions to reflect management’s guidance for lower revenues, with lower pricing expectation the largest element of adjustment. We now assume an average price of $1,450 per MHz per month in FY18 compared to $2,000 per MHz per month previously. In addition, we now assume no sales from HYLAS 3 once deployed.

We have assumed that the current year has been severely disrupted by the uncertainty surrounding the company’s financial structure and the negative impact of FX on European and UK revenues. Our revenue estimates reflect only a modest improvement in recurring revenues, which should start to accelerate as framework contract capacity builds over the next 18 months, filling existing capacity to levels previously anticipated for this June. HYLAS2-B should also make an increasing contribution. Further, we expect HYLAS 4 to start making revenue contributions from October 2017 and as this major capacity addition fills progressively, significantly boosting revenues.

There is some moderate cost base benefit resulting from a weaker sterling. For example most employment costs are sterling based, although the existing belief that excluding depreciation the cost base should remain relatively fixed remains.

The biggest change comes in interest where the face of the P&L has to show the interest rate related to the PIK of both FY17 and FY18 bond interest, even though this is a non cash item in the year of the PIK. In the cash flow it is adjusted out of free cash flow and into debt creation. Thus our balance sheet includes all the possible elements of PIK interest being undertaken, which we regard as being the worst case. We have not assumed a more favourable Super Senior Debt issue although this is clearly under consideration.

The Strategic Review and coincident Formal Sale Process started in July were both concluded by the announcement on 9 December 2016 of the proposed major restructuring of the group’s bond debt. During the review period, five offers for the company were received from commercial entities and private equity investors, but all indications of interest were rejected as failing to fully recognise the potential at Avanti. The announcement of the proposed deal with bondholders to refinance the company was announced on 20 December 2016, with the success of the consent solicitation process (approval) announced on 6 January 2017. The refinancing was completed on 27 January 2017. Despite the improved terms for bondholders, we would regard the deal as a vote of confidence from them in Avanti’s revised prospects given the recourse they have to the installed value of the space assets and associated ground infrastructure in case of default.

Unsurprisingly, the prospects for equity holders are diluted by the deal. While the issuance of new equity to bondholders as part of the refinancing is limited to just 9% of the increased share capital, the cash being diverted to the bondholders increases significantly. This is further compounded by the reduced sales and earnings expectations growth, which are likely to defer post interest cash generation by several years.

Nevertheless, the ability to continue to develop the satellite network and thus revenue potential remains in place, albeit likely returns are diminished and delayed.

There are two elements of improved medium-term liquidity for Avanti. A New Money Offer will provide $130m of cash, and deferral of interest payments totalling $112m will provide the balance.

The existing 2019 bonds, including those issued as a result of the PIK of the October 2016 interest payment total $685m, with a further $23m of interest accruing until 27 January 2017, the date of completion of the refinancing. This provides total of $708m nominal of Existing Notes that are subject to the refinancing.

The main Bond restructuring elements

Following the successful consent solicitation that provided the necessary permissions to proceed, Avanti has now completed the New Money Offer, including the issue of the 14.7m new shares.

Further to raising $130m of new funds for Avanti, the amendments allow Avanti to make the next three bond interest payments as PIKs. These are due in April 2017, October 2017 and April 2018. The cash savings Avanti can achieve on these payments in FY17 and FY18 aggregate $112m, a significant contribution to near term liquidity which can be triggered by the company on a minimum liquidity test as each payment becomes due. The penalty to Avanti and other stakeholders is that if all the savings were achieved, the nominal outstanding would increase by 16% to $947m from the revised gross bond debt of $840.5m following the completion of the refinancing transaction.

The bond deal involves a PIK arrangement for interest on Avanti’s outstanding bonds, similar to the process used for the October 2016 bond interest payment. Instead of paying the bond interest in cash, the company provides an alternative form of payment, in this case additional bonds issued at a rate 500-550bps higher than the coupons of the new classes of bond. That is to say if 10% cash interest is due on a bond, the company issues bonds with a nominal worth equivalent to 15% of the nominal value in issue. The new bonds carry the same cash coupons and terms as those already in issue, increasing the outstanding nominal by the 15% issued.

By doing this the company retains the cash that it would otherwise pay out in interest, but increases the overall nominal of the aggregate issue it will have to redeem at maturity. Clearly the use of the PIK is dilutive to other stakeholders.