On July 23, earth-imaging provider DigitalGlobe Inc. announced that it agreed to acquire competitor GeoEye Inc. for approximately $900 million. GeoEye’s principal shareholder, private equity firm Cerberus Capital Management, agreed to vote its shares in favor of the merger, making it almost certain to close in the absence of regulatory objections, which do not appear to be forthcoming. The deal puts an end to the U.S.-based duopoly that served primarily the U.S. government and will create the world’s largest commercial imagery provider. The merged company will keep the DigitalGlobe name. Under the terms of the deal, each GeoEye share will be exchanged for either 1,137 shares of DigitalGlobe common stock and $4.10 in cash, $20.27 in cash or 1.425 shares of stock. The purchase consideration represents a 34 percent premium on GeoEye’s July 20 closing price of $15.17 immediately before the merger announcement.

Two-into-one mergers of horizontal competitors usually do face antitrust and other regulatory obstacles, but DigitalGlobe-GeoEye is a special case. The merger announcement follows a warning of a critical reduction in the U.S. earth imaging market and the failure of a bold gambit: in May, GeoEye, the smaller of the two companies, with $437 million in market value, made an unsolicited offer for DigitalGlobe of $17 a share in cash and stock ($8.50 in cash, 0.3537 shares for each DigitalGlobe share), a premium of 33 percent above DigitalGlobe’s 20-day average, for a total value of $762 million. The offer was — evidently — backed by Cerberus. GeoEye’s offer was prompted by the U.S. Government’s announcement of a planned retrenchment of the U.S. National Geospatial – Intelligence Agency’s (NGA) “EnhancedView” program, which in August 2010 awarded 10-year contracts worth $3.8 billion to GeoEye and $3.5 billion to DigitalGlobe, a substantial percentage of each company’s revenues. GeoEye’s bid to acquire DigitalGlobe was made apparently with the realization that in the reduced market “there can be only one,” that the best defense is a good offense, and that an offer would be better made before the relative impact of the EnhancedView cuts on the two companies was fully known. The offer was described as a “Pac-Man” bid, after the early video game, in which a smaller company attempts to avoid being acquired by a larger competitor by acquiring the competitor first.

In the event, DigitalGlobe rejected GeoEye’s offer, and GeoEye’s stock fell more than 20 percent to trade at a recent low of 8.4 times earnings, rendering it immediately vulnerable to DigitalGlobe’s counter-offer two months later, following an announcement that GeoEye’s EnhancedView contract reductions would be negotiated first, with DigitalGlobe spared for the present, and perhaps entirely. GeoEye thus emerged from the series of events devalued by its rejected bid and apparently disfavored by the government customer on which both depended.

Revenue from the U.S. government should represent about half of the merged company’s estimated 2012 revenues of $600 million. DigitalGlobe’s pre-merger revenues were 63 percent attributable to government sales, meaning the merger dilutes the surviving company’s dangerous dependence on the principal government customer. DigitalGlobe estimates that the merger will create efficiency savings of $1.5 billion through 10 years, in large part from operating three Earth imaging satellites instead of the merging companies’ combined fleet of five. Each of the companies has a new satellite under construction. Under the merger plans, one of these will be mothballed and held as a spare.

The events leading up to this consolidation of the U.S. satellite Earth-imaging sector highlight not only the limitations of the “Pac-Man” technique, but the vulnerability of a company dependent on only one customer, especially when the customer has the right to renegotiate its contracts and all the more so when the customer is the government. There has been nothing to suggest government connivance in this consolidation, but the NGA had to be aware of the level of dependence by the two companies on its largesse, and that, by announcing reduction’s in GeoEye’s contract and not DigitalGlobe’s, it was, in effect, “picking a winner.” Investors generally love companies with multi-year, multi-billion dollar government contracts. As we discussed in a recent column on risk factors, seldom do investors take into account things like the rescindable nature of those contracts and the ability of the customer to change its mind and go elsewhere.

Owen D. Kurtin is a practicing attorney in New York City and a founder and principal of private investment firm The Vinland Group LLC.
He may be reached at [email protected].