GOGO – A Monopoly in the Making

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Gogo Inc (GOGO)
Stock Price: $22
Diluted shares: 84.2MM
Market cap: $1.85BN
Cash: $266MM
Working capital deficit, ex-cash: $54MM
LT Debt: $236MM
Other Liabilities, not including Deferred Taxes and Lease Incentives: $14.4MM
EV: $1.89BN

One of my secular investment themes is mobility (which I plan on covering in detail in a future note). GOGO is a pure-play on this theme and happens to be a really interesting story in a largely untapped niche. While I am a value investor and generally avoid overpaying, I do make exceptions when I believe a company is in the process of building a monopoly-like position in a large market. GOGO fits this profile which is why I’m a buyer post the 4Q13 earnings drop. Here are my notes:

GOGO brings the mobile internet age to aircraft via 3 products: Gogo Wifi, Gogo Vision, and Gogo Text & Talk. Each of these products could stand on its own; together, they make Gogo the communications nerve center for an aircraft and the undisputed leader in the industry. Some specifics on each product:

  1. Historically, Gogo Wifi has used a network of mobile broadband cellular towers that are beamed up instead of beamed down to deliver internet connectivity to aircraft passengers in the US (known as Air-to-Ground). However, recently Gogo developed a proprietary hybrid technology that combines Gogo’s Air-to-Ground network with the best aspects of existing satellite technologies (known as Ground-to-Orbit). This new Ground-to-Orbit (GTO) technology represents a leapfrogging of standard satellite service capabilities, expanding Gogo’s network capacity 20 fold from 3 megabits per second to 60 mbps (and that 60 mbps will only go up as newer satellites are launched). What Gogo has developed is a low profile antenna with high spectral efficiency and low latency. For consumers, nothing in the market is faster, more efficient or more reliable (for a technical discussion, see here – the video starts at 5:30 and ends at 24:30). For airline partners, Gogo’s GTO means they save tens of thousands of dollars each year in fuel burn versus the larger and heavier antennas on the market today. It’s a win / win. And finally, what this new GTO technology means for Gogo’s shareholders is that Gogo is now ready to begin its worldwide expansion. The network will be ready to launch in 2H14 and the first Gogo customer to commit to the service is Virgin America.
  2. Gogo Vision provides on demand entertainment and content streaming for airline passengers (TV shows / movies / etc). Compared to traditional seatback in-flight entertainment, Gogo’s technology offers airlines significant savings on installs while reducing fuel burn (e.g., instead of the expense of installing a screen in the back of each chair, airlines simply install Gogo’s wifi connectivity solution, which is 1 device and weighs about the same as two suitcases versus in-flight entertainment seatback systems that can weigh one ton in total). Really, it’s the whole “cloud versus installed software” debate – with the cloud, airlines don’t have to worry about maintaining the system or fixing broken screens, nor do they have to worry about content procurement, digital rights management, payment processing, customer service, etc. Gogo handles all of that and passengers get to use their own devices, which they nearly universally prefer (bigger screens, higher def, etc).
  3. Gogo’s Text & Talk allows passengers to make and receive calls and texts in the air just as they would on the ground, with their own phone number (this is an important selling point). Gogo is launching Text & Talk with commercial partners soon, perhaps as soon as a few months from now (it’s been in beta with approx. 2,000 customers; in the Company’s business aviation segment, they have already achieved >25% penetration with this product into their existing customer base). To use it, passengers simply install Gogo’s Text & Talk app and start texting (note: in certain markets like the US you are prohibited from making calls on commercial airlines; it’s my guess that texting will be enough to drive significant consumer adoption). Techcrunch’s Ryan Lawler recently reviewed the product saying, “I did a lot of cool things at SXSW 2014, but one of the coolest things I got to do was go for a trip in a private jet and test out some cool new technology from Gogo.” The entire video is worth a quick watch (click here).

I hope the above sheds a little light on the Company’s rather brilliant strategy which is, quite simply:

This cycle of better technology → more airplanes / partners → better products will lead – I believe – to one eventuality: a monopoly-like position for Gogo.

If this strategy sounds familiar to you, it’s the same playbook used by Elon Musk at Tesla – see The Secret Tesla Motors Master Plan:

Almost any new technology initially has high unit cost before it can be optimized and this is no less true for electric cars. The strategy of Tesla is to enter at the high end of the market, where customers are prepared to pay a premium, and then drive down market as fast as possible to higher unit volume and lower prices with each successive model.

I think what most people are missing here – particularly the ones who have been vocal opponents of Gogo’s service (see Harteveldt’s and Brancatelli’s comments here) – is (1) how entrenched Gogo is once its installed and (2) how a virtuous cycle of product improvement leads to a bigger airline network which leads to more capital availability which leads to a bigger network. There are also a few other reasons why I think there is a reasonable chance the business winds up as a natural global monopoly:

  1. Gogo signs 10 year exclusive contracts with its airlines partners, creating a significant and valuable moat.
  2. With every OEMs partnership or fractional jet owner partnership, Gogo becomes even more entrenched.
  3. Becoming a certified airline partner is a non-trivial task that provides more barriers.
  4. Heavy upfront capital expenditures (for product development, antennas, operating licenses, etc) virtually guarantee that once Gogo reaches a critical mass, no new competitor will want to enter the market.
  5. Securing satellite contracts requires significant payment guarantees and access to capital.
  6. The operational, technological and regulatory expertise required to get started in this market is tremendous.

I am not the only one that recognizes the beginning signs of a future monopoly. A class-action lawsuit that was originally dismissed is now back on with the plaintiffs accusing Gogo of overcharging for its service. According to the suit, Gogo “unlawfully obtained and/or maintained monopoly market power in the United States market for inflight Internet connectivity on domestic commercial aircraft by resort to anti-competitive conduct that includes a series of long-term exclusive contracts with the major domestic airlines in the United States. These exclusive contracts have the purpose and effect of thwarting competition on the merits and on price, and [they] have permitted Gogo to charge consumers like Plaintiffs and the members of the class they seek to represent supra-competitive prices.”

District Judge Edward Chen wrote that the court is also “not persuaded” by Gogo’s argument that it’s easy for airlines to get out of the contracts they have signed with Gogo. Gogo also tried to argue that – despite being installed in 80% of the wifi enabled planes in the North American commercial aviation market – it is a competitive space. They cited Global Eagle’s Row 44 unit (partner of Southwest Airlines), Viasat (JetBlue), OnAir (British Airways and more internationally), Panasonic Avionics (United Airlines), and Thales Group (LAN Airlines) as competitors. If you care, you can read more about the case here.

Personally, I am encouraged by this news because it confirms my thesis (Gogo’s alleged “overcharging” also happens to check off one of Warren Buffett’s investment boxes: “The single most important decision in evaluating a business is pricing power.”). Does it make me fearful of the Government breaking up Gogo because it has a monopoly position on a captive audience for a few hours on a flight? Not. One. Bit.

I believe the Gogo story is in its very early stages. There are three reasons why I think it’s inevitable that every major airline will be connected over next 5 – 10 years (I’ve already stated above why I think Gogo will likely be the provider of choice):

  1. Government rule changes: The FAA recently changed its rules around the use of personal electronics, a rule which allows wifi to be used during all phases of a commercial flight, but still prohibits the transmission of data via cellular signals (4G, LTE, etc). This is a powerful tailwind for the industry and for Gogo specifically. “Passengers will eventually be able to read e-books, play games, and watch videos on their devices during all phases of flight, with very limited exceptions.”
  2. Consumer demand: Michael Small, CEO of Gogo said it best: “… the [FAA] rule was changed because of customer pressure to have more access to the devices. […] The world wants to be connected everywhere. The ruling is a political (and) regulatory expression of that.”
  3. Airline demand: Airlines view in-flight Wi-Fi as a “huge competitive advantage”. At some point, it will become a huge competitive disadvantage if they don’t offer it. A side note: this will be an important point in the future when Gogo goes from paying for an airplane installation to getting paid for the installation by the airline.

All three of these elements are working together to the benefit of Gogo. The FAA rule change stokes consumer demand (the thought being that consumers are less likely to stow their devices in the overhead bin for the duration of the flight) → consumer demand stokes airlines to partner with Gogo → Gogo’s network expands.

If I’m right and 75% of commercial aircraft worldwide get connected over the next few years, and if Gogo can capture 50% of that market (they have 80% today), what is this business worth?

To answer that question, you must first piece out Gogo’s business aviation segment, a hidden gem in an already interesting story. In its business segment, Gogo operates as Aircell where they have been providing telecom services to business jets for more than 20 years. What started out as a simple analog telephone product has evolved into the most trusted communications platform on the market. Gogo’s Aircell is so entrenched that they are now offered at the factory floor by every major business aviation OEM.

Gogo Business Aviation Partners

At YE13, Gogo’s Aircell served 7,222 business planes (5,175 with Iridium satellite communications systems [basically voice service and SMS / light email data] + 2,047 Gogo Biz systems [voice, internet, email and more… about what you’d get at a coffee shop]). Of the business planes outfitted with communications technology, Aircell has an estimated 63% share in narrowband and an estimated 93% share in broadband. As more planes adopt broadband technology (only ~10% of business aircraft in North America have it), Gogo will benefit with higher revenues and even better operating margins.

Let’s have a look at the numbers… in 2013, the BA segment generated over $127MM in revenue and $51MM in EBITDA (40% margins), up 30% and 42% Y/Y respectively.

Management has said the business aviation segment has “low capital requirements” and “generates lots of free cash flow”. While I’m waiting for management to get back to me on those specifics (you can see my questions below – feel free to email me or comment below if you have any others; I’ll add them and report back after my call with the Company), let’s make some general assumptions. Let’s assume this business segment grows at 18% next year (which can be achieved through a combination of new plane builds, higher broadband penetration within the existing business aircraft market and via pricing power; management has guided to 27% growth so I’m haircutting that a bit here). At 18% top line growth, 40% EBITDA margins and $10MM in CapEx, this business will generate $50MM in pre-tax free cash flow next year. I believe a monopoly business with significant and growing free cash flow is worth 12x – 20x FCF. If you put a 15x multiple on the after-tax FCF (~7% FCF yield) then the business aviation segment alone is worth nearly $500MM.

So what about the commercial aviation segment… what’s that worth?

Let’s assume long term that Gogo can convince one out of every 10 passengers to use Gogo during their flight (in 4Q13 they had a 7.23% take rate; my assumption is that the FAA rule change combined with Gogo’s Text & Talk product combined with better GTO technology lifts the take rate to 10%). Further assume that the average revenue per session falls from $10.29 to $9.00 (I am assuming that a combination of lower price and mix shift brings the average price down 13% from 4Q13 levels). The only assumption left to make is the number of aircraft Gogo has in its network. At YE13, there were 2,032 commercial aircraft in the Gogo network (via 9 major airline partners). There are approximately 17,000 commercial aircraft worldwide, expected to grow over 100% to 36,000 over the next couple decades. Let’s assume 20k aircraft, 75% of which get connected and Gogo can capture 50% of the market. Using these assumptions, Gogo will generate over $1BN in service revenue alone (not including equipment revenue or upside from new product introductions or new revenue sources such as advertising).

Gogo Revenue Model

What is $1BN in future service revenue worth today? For this business I’d be willing to put a 3x multiple on it (feel free to use your own judgment based on SaaS comps or early growth telecom comps).

By my math, Gogo’s EV should be $3.5BN. Take out the $40MM in net liabilities and you get an equity value of $3.46BN, representing upside of almost 90%. I believe Gogo is worth over $40 / share.

You can test your own sensitivities in my simple model here.

Other notes

Questions for Management

  1. What is the historical CapEx in business aviation segment? Breakdown between growth and maintenance CapEx?
  2. Same question for the consumer aviation segment.
  3. Can you describe the timeframe to a transition to a CapEx-lite business model? What are your assumptions around that?
  4. Provide some insight into the underlying cohort metrics … are you noticing that when someone becomes a customer, their spend over time increases? Are new customers today spending more than new customers from 12 months ago?

6 Responses
  • Mac Reply

    Has anything fundamental changed here since your initial coverage of it? – thanks for your thoughts

    • analyst Reply

      The short answer is no. Some notes:

      – GOGO is now in 20% of the world’s aircraft.
      – GOGO has a backlog of 250 additional aircraft in North America and they have only installed 25 out of 300 planes for Delta and JAL internationally (they are accelerating installations in 2H14).
      – GOGO is rolling out new products (Gogo Vision, Talk & Text) – these revenues will start to appear in the later part of this year.

      For me, this isn’t about profits yet… it’s a race for the future: who’s going to become the installed partner in consumer aviation? GOGO has a huge lead, but competition isn’t sitting idle: AT&T is coming into the space in late 2015, for example. My money is on GOGO… I believe they are just too far ahead in both relationships and technology.

      Here are the latest key stats: https://www.dropbox.com/s/52rthg8tpdyjruz/GOGO%20Key%20Metrics.xlsx

  • analyst Reply

    An interesting data point on installed in-flight entertainment systems:

    One economics professor in Norway calculated last year that a reduction in weight on a plane of one kilo could result in fuel savings of $3,000 per year.

    If that’s true, and we assume an IFE system weighs one ton, then airlines could save $3 million, per year, per aircraft, by replacing legacy in-flight entertainment systems.

    http://www.cnn.com/2014/08/12/travel/secrets-of-in-flight-movies/

  • Ryan Reply

    Any thoughts on Global Eagle (ENT)?

    Their satellite strategy seems superior

    • analyst Reply

      Why do you think they have a superior strategy?

  • Ryan Reply

    GOGO has dominance in the US (one could argue that all they can do is lose market share from here) but the growth game is worldwide where they compete at a slight disadvantage. GOGO’s contracts allow for an exit provided that a competitor has a materially better offering. To be fair ENT’s contracts also don’t have a specific penalty but an exit would indeed be a breach. I think this is where some of the sell off came from when AT&T announced entrance.

    This is a commodity product going forward. ENT’s deal with boeing to offer pre-installed connectivity on the 737 and 787 gives an advantage and possibly looks like an endorsement. It is also much more convenient for the airlines who have to take a plane out of service for a while to drill holes in it and install the hardware.

    I’m new to the technology involved but it looks like GOGO is late on delivering their satellite solution and that it is taking longer than they had guided. It looks like there is still some big spending to do as they move from ATG to hybrid to satellite whereas ENT is ready to play and scoring.

    ENT has 50-60% share of the in-flight content space, offering even live TV, which might give them an advantage near term in scoring contracts but my guess is people will prefer to go with their own familiar content eventually. ENT looks to have seen the international opportunity better and started with a white label solution, with worldwide connectivity (available over water and in rural areas unlike the ATG technology that GOGO is still saddled with and trying to move away from), and wins like Southwest and Boeing as social proof.

    Having said all that I only started looking at the industry recently.

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