|Shares Out. (in M):||59||P/E||13.8x||11.5x|
|Market Cap (in $M):||818||P/FCF||9.5x||8.4x|
|Net Debt (in $M):||-122||EBIT||100||115|
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Some tables and charts could not be copied into VIC; a version including additional tables and charts is available here:https://docs.google.com/open?id=0B8JQBxIp5NxKWk0tQ0JtcDRRc28
At current levels, I believe that Orbital Sciences (NYSE: ORB) presents a compelling risk/reward profile. ORB is a specialized commercial and government/defense developer of rockets, satellites, and other space systems. Generally, ORB’s strategy has been to focus on products in smaller and niche markets not typically served by its competitors, mostly the large defense primes.
Generally, I am not a fan of defense businesses for a variety of reasons. However, I believe pockets of opportunity exist and that ORB qualifies as such an opportunity. Moreover, I do believe that if one is seeking a hedged trade, ORB pairs nicely against a basket of or certain specific f defense names. Additionally, ORB has a near-term catalyst that should remove a significant overhang and likely boost the stock.
Downside protection is a function of three factors:
1) On a reported basis (for EV), ORB trades at ≈4.6x 2013 EBITDA; adjusted for excess working capital (which I will discuss later) ORB trades at ≈3.9x 2013 EBITDA; using the same EV figure, ORB trades at EV / 2013 FCF (fully taxed, even though ORB will be paying a materially lower rate through 2013 and part of 2014) of 7.0x
2) ORB’s balance sheet is pristine with a strong net cash position and (unlike the vast majority of defense companies) no pension liabilities
3) ORB trades at a modest <1.4x TBV
Aside from valuation itself – which most certainly is not a sufficient condition for defense stocks – upside is a function of the following factor:
Since 2009, ORB has been devoting substantial resources towards the development of their Antares rocket and associated Cygnus payload towards fulfillment of ORB’s COTS/CRS contracts with NASA [see later in memo for explanation]. The development has resulted in meaningfully reduced operating margins (as a result of much higher than normal R&D spend) and negligible/negative FCF (as a result of much higher than normal CapEx). ORB is very close to the inflection point when this program will move from development to product, resulting in expanding operating margins and substantial FCF generation. Specific catalyst for 2H12 exists and FCF generation should begin in earnest in 2013. In late August / early September, ORB is scheduled to conduct the ‘hot fire test’ for the Antares rocket. A successful test should substantially re-risk the Antares development and provide confidence for the 2013 commercialization.
Additionally, the following is worth mentioning as I believe it is the reason why ORB’s stock faced very significant pressure in 2Q12 (descending to 6+ year lows): the market was very concerned that ORB intended to acquire the satellite manufacturing business of LORL. An acquisition would have required ORB to take on significant amount of debt and/or tap the equity markets at very depressed levels. Given the size of the acquisition, ORB would essentially be betting the company on the deal, and the acquisition would remove the possibility of ORB itself being a takeover candidate (strategic or financial), and would send some ill signals about capital allocation and the importance of shareholders returns. In the end, ORB did not acquire the LORL business, but it appears that they did look at it but were not willing to pay the price which it ultimately fetched. Accordingly, I believe the lows ORB reached in May/June were influenced by factors outside of the business itself.
I will provide only key points on the business segments here, but am happy to answer any questions for further details – the Company presentation and 10K also walk through the segments and financial targets for the segment.
ORB operates under three segments:
1) Launch Vehicles Segment
3 main products:
- Space Launch Vehicles – rockets used to deliver various payloads into orbit
- Interceptor Launch Vehicles – rockets used in missile defense to intercept attacking missiles (note: a potentially inexpensive way to invest in a potential Iran strike and long-term defense impact)
- Targets and Sounding Rockets – ‘practice’ rockets used to test missile defense systems
Other than the Antares rocket (discussed later), all of ORB’s launch vehicles are already fully developed and in production.
ORB is targeting 6-8% revenue growth from 2011-2014 and operating margins of 8-9% in the segment by 2014.
2) Satellites and Space Systems Segments
3 main products/services:
- Communications satellites
- Scientific satellites
- Space technical services
ORB currently has under contract 15 satellites and major systems for 2012 through 2016.
Importantly, this segment contains effectively no R&D risk as all primary satellite product lines are fully developed and in production.
ORB is targeting 4-6% revenue growth from 2011-2014 and operating margins of 7-8% in the segment by 2014.
3) Advanced Space Programs Segment
This segment contains (a portion of) ORB’s work on the COTS / CRS program (discussed later).
Additionally, within this segment ORB develops satellites for small- and medium-class satellites primarily used for national security space programs and to demonstrate new space technologies
ORB is targeting 8-10% revenue growth from 2011-2014 and operating margins of 7-8% in the segment by 2014.
ORB commands impressive market share in its core verticals:
- 60% share of the small launch vehicles market (Launch Vehicles)
- 55% share of the small communications satellite market (Satellites and Space Systems)
- 40% share of the interceptor market (used for missile defense) (Launch Vehicles)
Antares / Cygnus / COTS/CRS:
ORB is currently in the final development stages for the two interrelated NASA programs:
1) Commercial Orbital Transportation Services (COTS)
2) Commercial Resupply Services (CRS) program
Both COTS and CRS are part of NASA programs aimed at coordinating the delivery of crew and cargo to the International Space Station (ISS) by private companies. Elon Musk’s SpaceX’s recent much heralded launch and docking of their rocket to the ISS was part of the COTS/CRS program.
COTS and CRS are technically two distinct programs: the former relates to the development of the launch vehicles and involves a number of ‘Space Act Agreements’ (i.e. milestone based payments) but does not involve any binding contracts; the latter relates to the actual delivery of cargo to the ISS and involves binding contracts to deliver cargo to the ISS.
In December 2008, NASA announced that ORB and SpaceX were each awarded CRS contracts (http://www.nasaspaceflight.com/2008/12/spacex-and-orbital-win-huge-crs-contract-from-nasa/):
- ORB: a minimum of eight missions valued at ≈$1.9bn
- SpaceX: a minimum of twelve missions valued at ≈1.6bn
- The most important component of ORB’s COTS/CRS program is completing the development of their medium-capacity rocket, Antares (formerly referred to as ‘Taurus II). ORB is in / approaching the final stages of testing Antares.
- Antares will be used initially on the COTS and CRS programs with NASA to deliver cargo to the International Space Station.
- Beyond its importance to COTS/CRS, Antares will increase the payload capacity of ORB’s space launch vehicles to approximately 12,000 lbs. for low-Earth orbit (LEO). Accordingly, Antares will meaningfully expand the ORB’s launch vehicles product offering. ORB plans market the Antares rocket to other US Government and commercial customers.
Presently, the most critical events for ORB relate to the testing of the Anteres rocket. Unfortunately, the timing of the Antares test launches has been delayed repeatedly. The delays related to Antares have come from various sources. Issues surrounding the launch pad and launch complex (completion of construction, testing and certification of infrastructure) have caused the most recent set of delays. But there have been other causes including dealing with subcontractors as well as items internal to ORB. Generally, these are just the sort of projects that typically experience repeated delays.
However, ORB’s credibility with regards to the timing of tests is quite suspect. In fact, I do not have much confidence that the most recent timeline provided by ORB (on the Company’s 2Q12 CC) will in fact be realized. However, I do believe that ORB is certainly in the final months of Antares development / testing.
Following certification of the launch site, between August/September and December 2012, ORB will conduct three major tests (note: all tests technically fall under the COTS, and not the CRS, program). As currently envisioned, the schedule is:
- Late August / early September – first stage test (hot fire test)
- Late September / early October – first test launch
- December - COTS demonstration mission to the station
The hot fire test will be critical in evaluating the likelihood that Antares moves ahead as planned – i.e. a success would represent a very significant risk reduction. If the hot fire test is able to run for its full duration and nothing explodes, that is a good sign. Following the hot fire test, it will take about a week for ORB to confirm all technical details.
Will the Anteres rocket be successful?
This is obviously a very near term and significant risk. What we are relying on is the following:
- ORB’s experience in launching vehicles into LEO is unrivaled, having successfully completed more launches than any entity other than NASA.
- The CEO has stated that ORB would not put a rocket on the stand unless they were 99% sure it was going to work. [Insurance companies underwrite to an 11% failure rate for LEO rockets.]
- Based on our discussions with industry participants, no specific concerns have been cited and ORB’s expertise and generally strong tract record are repeated themes. The success of SpaceX is not a direct read through to ORB but does provide clear demonstration of feasibility.
Of course, ORB has suffered rather well publicized failure with their Taurus XL rocket [Antares was to be named Taurus II until the failure of Taurus XL]. On two consecutive launches in 2009 and 2011, Taurus XL failed when the nose cone did not separate to deliver the satellite. ORB is using a different cone for the Antares rocket.
What happens if Antares fails?
The answer to this really depends on the nature of the failure. The Company can’t envision a scenario in which an initial test flight reveals a flaw so fundamental that the entire program would be killed (of course, such scenarios are possible and in which case I’d estimate that the stock probably declines $2-$3):
However, various flaws in design could emerge which would require further work. ORB would not have to use its own money to redevelop the rocket, rather NASA would provide the funding if it wanted a redesigned rocket.
There is no question that further delays would be a negative for the stock. There would be two material impacts as relates to NT results:
1) Baked in ORB’s 2012 guidance are higher margins for CRS/COTS based on completion of tests in 2012; failure would result in ORB not being able to book higher margins and operating income (relative to guidance) would be negatively impacted by ≈$10mm.
2) A delay in successful tests would result in a delay in unlocking the receivables related to mission success (see discussion later related to NWC).
Backlog:Currently, ORB’s backlog is $5,170 ($2,180 firm; $2,990 unfunded) – not very far off from the historical peak reached in 1Q09. Over the last 10 quarters, ORB’s book/bill ratio has averaged 152.5%. Whereas most defense companies are sitting on <1-1.5 years of backlog, ORB sits on more than 3 years of backlog. And whereas most defense companies are seeing book/bill ratios <1, over the last 10 quarters ORB’s book/bill ratio has averaged 152.5%. 2Q12 was especially strong with a book/bill ratio of 234.3%.
|Total Backlog||$ 4,570||$ 5,600||$ 5,300||$ 4,900||$ 5,290||$ 5,170||$ 5,170|
|Total Orders||$ 655||$ 1,600||$ 255||$ 275||$ 276||$ 380||$ 870|
|Backlog Growth - YOY||4Q10||1Q11||2Q11||3Q11||4Q11||1Q12||2Q12|
|Backlog Growth - Sequential||4Q10||1Q11||2Q11||3Q11||4Q11||1Q12||2Q12|
|Revenues||$ 346||$ 318||$ 351||$ 342||$ 335||$ 338||$ 371|
ORB’s backlog provides the Company very strong revenue visibility. For 2012-2014, ORB’s backlog covers 95%, 75%, and 50% of projected revenue for each respective year.
Although the Antares tests post the most significant near term risk, the more generalized risk facing ORB (and all defense names) is sustainability of government spending.
ORB’s primary government exposure is through NASA and the Missile Defense Agency (MDA)
NASA:As regards NASA, there are some key points around NASA’s 2013 budget proposal (http://www.nasa.gov/news/budget/index.html) as it relates to ORB. The key upshot from the budget proposal is that the International Space Station (ISS) is both the largest line item in the NASA budget as well as the only continuously growing line item in the NASA budget (http://www.nasa.gov/pdf/632697main_NASA_FY13_Budget_Summary-508.pdf).
In short: the ISS is the most well funded project under NASA purview and within ISS, the ‘ISS Crew and Cargo Transportation’ project is the most well funded item. ISS is clearly a priority of NASA’s. Accordingly, it would seem reasonable to expect that so long as NASA receives funding approximately in line with anticipated level, the CRS program should be secure from a funding perspective.
[The other area within NASA of importance to ORB is ‘Science’ – in the budget summary (http://www.nasa.gov/pdf/632697main_NASA_FY13_Budget_Summary-508.pdf), the 2013 request of $4.91bn is ≈3% below the allocated amount for 2012. However, the major decline is within ‘Planetary Science’, a segment with which Orbital is not involved. Excluding ‘Planetary Science’, the total ‘Science’ budget shows y/y growth.]
Missile Defense Agency:
It is more difficult to untangle ORB’s exposure to the MDA budget. Overall, the MDA budget will be down in 2013 vs. 2012. ORB’s 2012-2014 guidance assumes continued weakness in the MDA budget.MDA – Historical Funding (http://www.mda.mil/global/documents/pdf/histfunds.pdf):
The MDA 2013 budget proposal can be found here - http://www.mda.mil/global/documents/pdf/budgetfy13.pdf:
Based on our discussions with industry observers and our reading of industry material, although certain priorities within MDA are shifting a wholesale and dramatic reduction in MDA spending is not anticipated.
Financial Targets and Valuation:The analysis below is based on ORB’s stated financial targets.
|Valuation||2012 Range||2013 Range||2014 Range|
|Revenue||$ 1,450.0||$ 1,500.0||$ 1,537.0||$ 1,620.0||$ 1,629.2||$ 1,749.6|
|Y/Y revenue growth||6.00%||8.00%||6.00%||8.00%|
|Operating income margin||6.50%||7.00%||7.00%||7.50%||7.50%||8.00%|
|EBITDA||$ 130.3||$ 141.0||$ 143.6||$ 157.5||$ 158.2||$ 176.0|
|EV / EBITDA - based on current EV||5.3x||4.9x||4.8x||4.4x||4.4x||4.0x|
|Operating income||$ 94.3||$ 105.0||$ 107.6||$ 121.5||$ 122.2||$ 140.0|
|D&A||$ 36.0||$ 36.0||$ 36.0||$ 36.0||$ 36.0||$ 36.0|
|NOPAT at 35.0% tax rate||$ 61.3||$ 68.3||$ 69.9||$ 79.0||$ 79.4||$ 91.0|
|CapEx - maintenance||(27.5)||(27.5)||(27.5)||(27.5)||(27.5)||(27.5)|
|Unlevered maintenance level FCF||$ 69.8||$ 76.8||$ 78.4||$ 87.5||$ 87.9||$ 99.5|
|Unlevered maintenance FCF yield - based on current EV||10.0%||11.0%||11.3%||12.6%||12.6%||14.3%|
|CapEx - actual||(140.0)||(120.0)||$ (27.5)||$ (27.5)||$ (27.5)||$ (27.5)|
|Unlevered actual FCF||$ (42.7)||$ (15.8)||$ 78.4||$ 87.5||$ 87.9||$ 99.5|
|Net debt - beginning of period||$ (121.5)||$ (121.5)||$ (105.7)||$ (105.7)||$ (193.2)||$ (193.2)|
|Net debt - end of period||$ (78.8)||$ (105.7)||$ (184.2)||$ (193.2)||$ (281.1)||$ (292.7)|
|EV - end of period||$ 738.7||$ 711.7||$ 633.3||$ 624.3||$ 536.3||$ 524.8|
|EV / EBITDA - based on period EV||5.7x||5.0x||4.4x||4.0x||3.4x||3.0x|
|Unlevered maintenance FCF yield - based on period EV||9.4%||10.8%||12.4%||14.0%||16.4%||19.0%|
[Note – my analysis fully taxes ORB’s cash flows. However, ORB currently has NOLs of ≈$80mm and other tax credits of ≈$30mm. In total, those tax shields are worth ≈$.65/share. ORB currently pays a very low tax rate but expects the tax rate to increase to 35% over the next 2 years.]
Early in the memo I mentioned that ORB’s adjusted EV is lower than its reported EV. The reason for that is ORB’s net working capital currently stands at $121.7mm. That number has grown substantially (4Q09: ($60.7mm); 4Q10: $21.7mm; 4Q11: $58.4mm). From 2003-2011, ORB’s net working capital averaged ≈$4mm. The reason for the working capital builds relate to the COTS/CRS project and the structure of milestone payments. Upon successful testing of Antares, ORB will receive substantial milestone payments and much of ORB’s working capital should be recaptured as cash. If we give ORB full credit work its working capital surplus, EV is reduced to ≈$572mm and ORB’s valuation multiples compress meaningfully.
ORB has historically generated substantial FCF and management is genuinely and highly focused on FCF generation. Moreover, ORB has historically returned substantial FCF to shareholders in the form of share repurchases. Between 2004 and 2009, FCF averaged $74mm/year on average revenues of $912mm. Over that time period, ORB repurchased $200mm+ of shares (≈20% of company).
I believe that ORB is at an inflection point and will begin generating prodigious FCF in 2013. I believe it is guaranteed that ORB will re-initiate their share repurchase program and it is very likely that ORB will initiate a dividend.
I believe that by year end 2013 ORB will have ≈$300mm in net cash (assuming no share repurchases or dividends in the interim) and will be generate ≈$83mm in unlevered FCF in 2013 and ≈$93mm in 2014. Assuming reasonable 9x-11x unlevered FCF multiples on those numbers number plus net cash yields share prices of $17.65-$22.50.
Although the thesis does not at all rely on it, I do believe that ORB may represent an attractive target for either a strategic or financial buyer. Various defense companies are starved for growth, and ORB provides that. Given low cost of financing, an acquisition or ORB at a substantial premium to current price can be justified.
For a financial buyer, using very reasonable assumptions I can arrive at a ≈20% IRR (5 year exit) based on a purchase price 40%+ from current levels.
1) Antares tests fail
2) All risks associated with Government spending (general decline, NASA sequestration, etc.)
1) Successful Antares tests
2) FCF generation and return of cash to shareholders
1) Successful Antares tests
2) FCF generation and return of cash to shareholders
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