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GeoEye-2 illustration
GeoEye, whose GeoEye-2 satellite (above) is under development for launch next year, is seeking to acquire DigitalGlobe in large part to address potential major cuts in the US government’s EnhancedView imagery contracts. (credit: GeoEye/Lockheed Martin Space Systems Company)

EnhancedView’s cloudy future

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On Friday, commercial satellite remote sensing company GeoEye surprised many in the industry when it announced an unsolicited takeover offer of its chief rival, DigitalGlobe. GeoEye offered $17 per share, split evenly in cash and stock, to acquire DigitalGlobe, valuing the company at $792 million. The deal represented a 26 percent premium on DigitalGlobe’s stock price at the close of trading Thursday, although by Friday the stock soared to close at $16.44 a share.

“The considerable scale of the combined entity creates a strong domestic player in satellite imagery which could compete more effectively with foreign providers,” GeoEye president and CEO Matt O’Connell wrote in a letter to his counterpart at DigitialGlobe, Jeffrey Tarr. “The combination also allows for operating expense synergies and reduced capital requirements while better satisfying customer needs.”

“We believe GeoEye made its hostile bid in desperation due to highly publicized concerns about potential government decisions that may jeopardize their portion of the EnhancedView program,” DigitalGlobe said in its rejection of the offer.

In the press release, and a conference call with investors Friday morning, O’Connell said there had been discussions behind the scenes between the two companies about a potential deal for some time. “In these discussions, we discussed and agreed upon the merits of the combination, and the synergies that could be achieved by putting the two companies together,” he said on the call. DigitalGlobe, though, had rejected prior offers made in private. “We believe at this point in our dialogue that it’s appropriate to make our proposal public, because this is such an important matter for all shareholders to know about and consider.”

“We’re kind of puzzled as to the slowdown in discussions,” O’Connell said later in the call. “We’re not sure what their issues are.”

In a statement issued Sunday, DigitalGlobe formally rejected the GeoEye offer, saying it “substantially undervalues” the company and “does not adequately recognize DigitalGlobe’s superior track record of financial and operating performance as well as its constellation's greater capabilities.”

In that statement, DigitalGlobe confirmed that it had been in discussions with GeoEye since early February, when GeoEye first proposed an acquisition. DigitalGlobe, in turn, proposed its own deal to acquire GeoEye, with DigitalGlobe shareholders owning a 60-percent stake in the merged company. GeoEye rejected those offers, including one made over the weekend, and company officials now said they were no longer interested in discussing any kind of merger or acquisition for the time being.

“Given the abruptness of GeoEye’s most recent proposal and the companies’ past discussions, we believe GeoEye made its hostile bid in desperation due to highly publicized concerns about potential government decisions that may jeopardize their portion of the EnhancedView program,” Tarr said in Sunday’s statement.

That comment touches upon the underlying issue that has likely been driving these proposed deals over the last three months, as well as creating concern in the commercial remote sensing industry in general. In 2010, the National Geospatial-Intelligence Agency (NGA) awarded both companies with “EnhancedView” contracts with a combined value of $7.3 billion over ten years. The contracts are designed to cover the purchase of satellite imagery provided by the companies for use by various US government agencies.

However, the Defense Department, in its fiscal year 2013 budget proposal, is seeking to dramatically cut the funding available for the EnhancedView contracts. Although the details of the NGA budget proposal are classified, industry sources told Reuters last month that the administration was proposing to cut EnhancedView funding from $540 million to $250 million. Defense Department officials had previously indicated they would cut funding for EnhancedView by an unspecified amount as part of broader efforts to trim defense spending.

Those potential cuts were discussed at a Space Enterprise Council event on Capitol Hill one week before GeoEye’s public offer to acquire DigitalGlobe. Industry executives, representing not just the imagery providers but other suppliers and customers, as well as government officials, said the proposed cuts could have a devastating impact on the commercial imagery industry in the US at a time of growing international competition.

“You can’t tell industry that we need you to bring these novel approaches forward, we need you to invest along with us, we need you to share the risk with us, and then, six months into a ten-year program, propose cuts,” Schmackpfeffer said of the proposed EnhancedView contract cuts.

The EnhancedView cuts are a major concern because they represent a major portion of both DigitalGlobe’s and GeoEye’s revenues. Bill Wilt of GeoEye said at the forum that the EnhancedView contracts represent 60 to 70 percent of the company’s business. (In the conference call Friday, GeoEye officials said US government agencies combined accounted for 66 percent of total revenues in the latest quarter.) Cutting the EnhancedView contracts in half, he warned, would “gut the business case” for the company.

The EnhancedView contracts, the latest in a series between the government and commercial providers that previously included the ClearView and NextView contracts, have been hailed in industry as a good example of public-private partnerships that give companies a strong base of business that they can build upon and also leverage to gain outside financing to cover the development of satellites. That partnership, executives worried, could be jeopardized if the EnhancedView contracts are cut.

“You can’t tell industry that we need you to bring these novel approaches forward, we need you to invest along with us, we need you to share the risk with us, and then, six months into a ten-year program, propose cuts,” said Kyle Schmackpfeffer of ITT Exelis, a company that has developed imaging systems for both DigitalGlobe and GeoEye, at the Capitol Hill forum. The six months he was referring to were earlier, smaller cuts proposed by fiscal year 2012 for EnhancedView.

“EnhancedView was a really good idea at the time by having a public-private partnership. Wall Street was involved, and there was a lot of support,” said Eve Douglas of the Department of Commerce’s Office of Space Commercialization. If the proposed cuts go through, she predicted, Wall Street was unlikely to invest in this industry for the foreseeable future.

As the future of EnhancedView is up in the air, the leadership position DigitalGlobe and GeoEye have had in the commercial market is being threatened by a growing number of non-US providers offering imagery that is approaching the resolutions provided by US commercial satellites. At the time the latest commercial remote sensing policy was issued in 2003, Douglas said, US companies provided imagery with resolutions of about 0.6–0.8 meters, while the closest international competition was from Israel’s EROS satellite, at 1.9 meters. Today, US companies can provide imagery with resolutions of about 0.4 meters, but imagery is now also available from foreign providers at 0.5–0.7 meters, with others proposing satellites for launch in the coming years that could go down to 0.25 meters.

“The statement that the US is no longer the sole market leader in the commercial remote sensing industry is true,” she said.

Industry officials also tried to make the case that the imagery they provide is valuable to government users, particularly military forces in the field. Commercial imagery, Wilt said, is particularly valuable since it can be more readily shared with both other nations’ militaries and with nongovernmental organizations than that provided by intelligence satellites. Wilt recalled talking with one person with the Pentagon’s Africa Command, or Africom, who said they were particularly reliant on images provided through EnhancedView. “We live or die with commercial imagery,” Wilt recalled that officer saying.

“If you put the two companies together, what you could do is rationalize the constellation” by eliminating at least one replacement satellite in the future, GeoEye’s O’Connell said.

The idea of a merger or acquisition that combined the two EnhancedView providers didn’t come up at the Capitol Hill forum, but officials with both companies suggested in recent days that it would be a way to deal with the proposed budget cuts. “Given this uncertain political and fiscal climate, we believe it is in our mutual interest to provide our customers with creative solutions to problems rather than passively speculate on one or another outcome,” O’Connell said in his letter to DigitalGlobe.

“Competitors are always going to overbuild each other,” O’Connell said in Friday’s call, referring to the satellite constellations operated by both DigitalGlobe and GeoEye. “If you put the two companies together, what you could do is rationalize the constellation” by eliminating at least one replacement satellite in the future.

DigitalGlobe acknowledged similar benefits in its rejection of GeoEye’s offer, but said it would wait until the conclusion of the 2013 budget process—which may not be until the end of this calendar year—before making a decision on whether to again pursue some kind of deal with GeoEye. “We continue to believe there are merits to a potential acquisition of GeoEye, but at this time, we also believe that it is in the best interests of DigitalGlobe’s principal constituencies, including our shareholders and all of our customers, to await the conclusion of the government budget decision process and to gain clarity with respect to EnhancedView funding,” Tarr said in his letter to O’Connell on Sunday. “When the government reaches its decision, DigitalGlobe will consider whether to make a proposal to acquire GeoEye.”

However, unless there is a reversal by Congress of the administration’s proposal to sharply cut EnhancedView funding, it appear likely that some form of industry consolidation will take place. Whether it’s DigitalGlobe acquiring GeoEye or vice versa, or a decision by a third party to step in and acquire or otherwise take a major stake in one of the companies, remains to be seen.

This could also be a bellwether for moves elsewhere in the coming years in portions of the space industry where the government is a major customer and source of funding, such as space launch and NASA’s commercial crew and cargo initiatives. In an era of flat or declining federal spending, there may simply be not enough money to go around to all the companies that today have, or seek, a share of the market.