14 October 2009

Failure Subsidizes Success

Some successes would never occur if it weren't for prior failures.

My father was head of the Mechanical Engineering department at Utah State University when he and others started the annual Small Satellite Conference there. At one of the first instances of the annual event a group of engineers presented a revolutionary idea. A set of small relatively low orbit satellites could form a world-wide cellular phone and data network! Moving the satellites into low orbit would allow the use of simple antennas and satellites would hand off connections as they move past a customer the same way that cellular phone towers hand off as a mobile customer moves around the city.

iridium

The initial design was christened Iridium because it utilized 77 satellites -- the same number of satellites as the iridium atom has electrons. As the concept evolved, the number of satellites changed but the name stuck. Iridium is a mesh network; messages are collected at the nearest satellite to the customer then handed off from satellite to satellite until being relayed to a ground station. For such a mesh network to work reliably the entire constellation of satellites plus a couple of spares had to be in place.

The capital cost of launching a satellite network was enormous – estimated at more than $6 Billion. The first phone call was placed on 1 November 1998. Only nine months later they had to file for Chapter 11 bankruptcy protection; the expected business subscribers hadn't materialized. A Wikipedia article offers a number reasons for the failure including better ground-based cellular networks, inter-carrier roaming agreements, unappealing handsets, a bad pricing model and mismanagement.

I think the biggest problem was that real potential return wasn't enough to justify the original investment. If the eventual customer base had been accurately projected, the system would have never left the ground. (Puns are easy in this subject.) The Iridium system shut down service and was considering de-orbiting the satellites and ceasing all operations before the assets were purchased by a coalition of private investors in 2001. The purchase price? About $25 million.

Of course, the new investors had to plow a lot more money into the company to restart operations, run sales and marketing and so forth. Those numbers aren't available as Iridium is privately held but a good guess is a total investment of around $150 million. For the year 2008, ten years after operations started and seven years after the buyout, Iridium LLC reported $320.9 million in revenue with operational earnings (EBITDA) of $108.2 million. This means that the 2008 return-on-investment was around 72% for the buy-out investors. However, if the original investors had hung on instead of writing off most of their investment in 2001, the annualized return at the end of 2008 would only have been 1.8% – certainly not enough to justify a high-risk investment like this.

So, today we have a fantastic asset that supports military communications, offers live television reports from remote locations, keeps our Antarctic scientists in contact with home, provides continuous phone service to aircraft and ships worldwide, offers telemetry from automated outposts and a host of other services. The system is operationally profitable and earning enough money to be maintained and improved. The system exists because the business plan that convinced the original investors was fantastically wrong. Those investors took a loss but society benefitted.

The only other way I can think of for such a system to emerge would be for government to step in and offer a huge subsidy. What's better, subsidy from business failure or subsidy from government? I think we need both which is why I believe capitalist societies must preserve the freedom to fail.

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