Orbital Sciences Corporation (ORB) is one of two companies that provide cargo services to NASA. This status is beneficial for the company's prospects. However, the recent budget act stated that the US Government would cut its discretionary spending which means that in the long run this budget cut might have a negative impact on the company's margins. Since these governmental changes can significantly affect ORB I am interested in analyzing the company's prospects.
About the company:
SOURCE: Investor Presentation
Orbital Sciences develops and manufactures small and medium class rockets and space systems for civil governments, including the US Department of Defense, the National Aeronautics and Space Administration and other US government agencies, military, and commercial customers.
The company has three segments: Launch Vehicles, Satellite and Space Systems and the Advanced Space Program.
The Launch Vehicles segment develops and produces space launch vehicles, interceptor launch vehicles, interceptor boosters, target launch vehicles for missile defense systems and subordinal launch vehicles.
The Satellite & Space System segment develops and produces communication satellites and other space-based communications services. It also provides space systems, subsystems and a range of space related technical services.
The Advanced Space Program segment develops and produces human-rated space systems, planetary exploration, small and medium class satellites and related systems for national security space systems.
Orbital Sciences is expected to report annual revenues of $1.39 billion during fiscal year 2013 and the Launch Vehicles and Advanced Space Programs segments will each contribute 35%. The remaining 30% of the total revenue is expected to be generated from the Satellite and Space Systems segment.
SOURCE: Investor Presentation
The Mounting Backlog
The company reported a record backlog of $5.4 billion, with premium customers, as of September 30th, 2013. Backlog refers to the company's sales orders slated to be filled in the future. A large contract backlog reflects high revenue visibility. As shown in the following pie chart, firm backlog is approximately $2.02 billion while option backlog is about $3.38 billion. Current backlog provides excellent visibility of near-term revenue growth. Current backlog gives about 70% total revenue coverage through 2013 to 2015.
The company expects to convert $330 million of the 30 September, 2013 firm backlog into revenues in the fourth quarter of fiscal year 2013.
Segment-wise Division of Backlog
In the following chart segment-wise detail of firm backlog is given. About 45% of firm backlog will be from the Launch Vehicles segment. Firm backlog of the Satellite & Space Program segment and Advanced Space Program segment are 20% and 25% respectively.
The list details the components of firm backlog,
- Aggregate contract values for firm product orders excluding the portion previously included in revenues.
- Government contract orders not yet funded.
- The company's estimate of potential award fees.
As far as total backlog is concerned, the Launch Vehicles segment's backlog is contributing 50% to the total backlog while each of Satellite & Space Systems and Advanced Space Programs segments are contributing 25% to the total backlog.
The following list details the components of total backlog,
- Firm backlog
- Unexercised options
- Indefinite-quantity contracts
- Contract award selections etc.
The company has a total backlog of $5.4 billion, out of which 45 percent is expected to be realized by the end of 2015. The company's current net margin is around 5 percent, whereas the industry's net margin is 7.13 percent. I believe that the company's net margin will revert to industry's average in the near term owing to strong backlogs. For the purpose of intrinsic value calculation, I have assumed that the company will be able to convert $1.215 billion (50 percent of the 45 percent of total backlogs) of backlogs into revenues in fiscal 2014. Another assumption that I have used for the calculation is that the company's net margin will be 6 percent in fiscal 2014, which gives an EPS of $1.21 in the fiscal 2014. Using industry's price-to-earning of 20.5 times and net margin of 6 percent, the intrinsic value of the stock is calculated to be $24.72 which gives a capital return of 7.47 percent.
In the worst-case scenario, net margin of the company is assumed to be 5 percent in the fiscal 2014, and the backlog that is expected to convert in the revenue is $1.053 billion (50 percent of 39 percent of total backlogs) in the fiscal 2014. Using industry's price-to-earnings of 20.5 times and an EPS of $0.87 in fiscal 2014, the intrinsic value is calculated to be $17.85, which is 22.38 percent lower than the current stock price.
For the best-case scenario, I have assumed that the company will be able to covert 49 percent of the total backlog into revenues by the end of 2015. Using the assumption that the net profit margin will reach to level of 6.5 percent in 2014 and 50 percent of 49 percent of total backlogs will convert into revenues in the fiscal 2014, it gives an EPS of $1.31 in fiscal 2014. Using industry's price-to-earnings of 20.5 times and EPS of the company of $1.31, the stock's intrinsic value is calculated to be $29.16 which is 26.77 percent higher than the current stock price.(click to enlarge)On the flip side, in the best case scenario, where net margin is expected to reach 5.5% and backlog that is expected to be converted into revenue is 49%, the fair value of the stock is $30.81 which gives a capital return of approximately 34%.
Recent Development in Commercial Resupply Services
NASA's rival Space Exploration Technologies or SpaceX started working for NASA 18 months before Orbital Sciences. SpaceX has already completed a test flight and two cargo runs to the International Space Station. SpaceX and Orbital Sciences are the only two companies that are working for NASA. Charles Bolden, a NASA administrator, said in a statement regarding the completion of Orbital Science's successful test missions to the International Space System, "We are delighted to now have two American companies able to resupply the station… Congratulations to the teams at Orbital Sciences and NASA who worked hard to make this demonstration mission to the International Space Station an overwhelming success".
Year-on-Year, revenue decreased by 14% in the third quarter of 2013. Decline in revenues was primarily attributed to the decrease in sales of the Launch Vehicle and Satellite & Space Systems segments. Net income and operating income also decreased due to the decline in revenue in the third quarter on a year-on-year basis. However, this decline was partially offset by a $1.4 million reduction in interest expense as a result of a debt refinancing transaction during the last quarter of fiscal year 2012.
The company derives approximately 79 percent of its consolidated revenue from contracts with the U.S Government and its agencies or from subcontracts with U.S Governments contractors. Therefore, I believe that the company's operations and financial results will be impacted by the US Government's spending trends. Shifting priorities in the Department of Defense, NASA and other agency budgets and the types of contracts mandated by the US Government can also affect the company. These factors are beyond the control of the company and I believe that the shifting trend in the US government's spending might have a significantly negative impact on the company's bottom line.
The Budget Control Act of 2011 stated that the US Government would have to significantly reduce the federal deficit over ten years through caps on discretionary spending and other measures. Cut and caps on discretionary spending will save up to $925 billion over a 10 years period. Although Congress initially delayed the reduction in discretionary spending the US Government reduced discretionary spending to $1,213 billion in fiscal year 2013.Therefore, I believe that the Orbital Sciences' government customers will experience reductions in their budgets relative to the recent levels and this will eventually negatively affect the company's earnings.
Funding for Commercial Orbital Transportation Services' (COTS) demonstration mission including an Antares test launch and Commercial Resupply Services' (CRS) contract will remain unaffected by budget cuts. However, priorities regarding Earth and space science investigations are not yet clear. It is very probable that the NASA budget for these programs might be reduced because of a focus on other programs and this could have a negative impact on certain programs.
Moreover, the larger portion of Orbital's missile defense interceptor and target launch vehicle revenues comes from programs sponsored by the Missile Defense Agency (MDA). Therefore, I believe that due to the Budget Control Act of 2011, the company's earnings will decrease due to significant reductions in defense budgets over the next 10-year period.
Orbital Sciences has no direct competitors but I consider Lockheed Martin (LMT) and Raytheon Company (RTN) to be the main competitors of the company. Lockheed Martin manufactures target launch vehicles, interceptor launch vehicles and satellites that compete with the products of Orbital Sciences. Lockheed derives nearly all of its sales from government contracts. However, Lockheed also manufactures airplanes that Orbital does not. Orbital generates less revenue from US Government contracts in comparison to Lockheed. Therefore, I believe that due to the cut in discretionary spending Orbital Sciences' revenues will be greater than Lockheed's since Orbital's revenues are less dependent on US Government contracts.
As for as Raytheon is concerned, it competes with Orbital Sciences for the contracts of interceptor launch vehicles. It generates approximately 86 percent of revenue from contracts with the US Government which is higher than the revenue that Orbital Sciences generates from contracts with the US Government. Although, Orbital Sciences is less dependent upon contracts with the US Government than Raytheon, it is also less diversified than Raytheon. Raytheon also manufactures equipment for the US military.
Both competitors have the advantage of diversification over the Orbital Sciences; however, Orbital Sciences is also a fully horizontally and vertically integrated company. This competitive advantage gives the company an edge over its competitors in terms of lower cost of goods sold. Therefore, the company is in a better position to report higher margins than its competitors because of lower costs. Therefore, I believe that the being less diversified is compensated by the company's horizontal and vertical integration.
There are so many factors that I believe can have a significant impact on the company's performance. The company has the advantage of being fully vertically and horizontally integrated. Moreover, the company is between two companies that are providing cargo services to NASA. Therefore, I believe that the cut in discretionary spending will not have a significantly negative impact upon the company's performance. The company has a strong backlog that will convert into the revenues in the near future. Using the assumptions of net profit margin, industry's price-to-earnings and the backlog, fair value of the stock gives about 7.47 percent capital return under the base case scenario. While in the worst-case scenario, fair value of the stock is 22.38 percent less than the current price. However, in the best-case scenario, stock gives upside potential of 26.77 percent. As the downside potential is lower than the upside potential, therefore I believe that the stock is an outperformer.